The ABC’s of Annuity Investing

Chapter 10: NAIC Suitability

NAIC Suitability

2010 Suitability in Annuity Transactions Model Regulations

  The National Association of Insurance Commissioners (NAIC) adopted the 2010 Suitability in Annuity Transactions Model Regulations to set standards and procedures for suitable annuity recommendations by producers and to require insurance companies to establish a system of supervision.

  Specifically, the Model Regulation was adopted by the NAIC to do three things:

1. Establish a regulatory framework holding insurers responsible for ensuring the annuity transactions they underwrote were suitable based on specified criteria.
2. Require producers to be trained on the annuity provisions in general and specifically on the products he or she was selling or recommending.
3. Where feasible and rational, make the suitability standards consistent with those established by the Financial Industry Regulatory Authority known as FINRA.

  Insurance companies, under these Model Regulations, acquired duties regarding product compliance.  In general, prior to recommending a particular annuity to a consumer, the insurer or producer must make reasonable efforts to obtain consumer information that allows the insurer or producer to establish product suitability for that person’s personal circumstances.  Based on the information given by the consumer, the producer (or insurer if no producer is involved) must have reasonable grounds to believe the transaction is suitable for the situation.

  The producer may not dissuade or attempt to dissuade any applicant from providing accurate and truthful information on his or her application.  Why would a producer want to do that?  If some of the applicant’s information would show the product was not suitable the agent may not want to disclose it.

  If the consumer refuses to provide necessary information at the time of product application both the insurance producer and the insurer are released from suitability obligations.  Obviously, if the buyer gives wrong information, partial information, or no information at all, the producer and insurer cannot be expected to make an accurate determination of suitability.  Even in these circumstances, however, the producer or insurer must make the best recommendation possible with the information they have available.

  Some suitability requirements may apply under FINRA, which would apply to variable annuities.  The so-called “safe harbor” is intended to prevent duplicative suitability standards.

Suitability Information

What, exactly, does “suitability information” mean?  It means gathering and using information that is reasonably appropriate to determine the suitability of the product being recommended.  This information would include such things as age, income, financial objectives, time horizons, and other pertinent facts.

Some Repeated Information

  You will find that this chapter repeats some information found in previous chapters.  Since we wanted to make this a complete chapter on suitability, there was no way to avoid this.  Where states have initiated annuity suitability standards based on the NAIC outline, we wanted to put required information together in one complete chapter.

Selecting Appropriate Products

  There is no “perfect” investment vehicle and each vehicle carries some type of investment risk.  This is true of everything from stocks to saving accounts at our local banks.  In some cases the risk has to do with the type of investing, but in other cases it is inflation that robs us of our savings and growth.  The ideal investment vehicle would provide interest rates that are higher than the rate of inflation, without the risk of investment loss.  Such “ideal” investment vehicles do not exist.

  While there is no ideal investment, there is also no specific type of investment that is always wrong.  Each investment vehicle has qualities that work well in some specific conditions and qualities that make it unsuitable in others.  The goal is to identify the type of investment vehicle that best suits the investor’s needs and goals.

  Although this course deals with annuities in general, many professionals feel it is the emerging popularity of equity indexed products that has caused the states to begin requiring annuity training and suitability requirements.  Just like other annuities, equity indexed product are issued by insurers, but they have aspects that are not like the traditional fixed rate annuities most consumers are familiar with.  Equity indexed annuities are not variable annuities; they are fixed rate annuities, but very complicated fixed rate annuities.

What is an Annuity?

  What exactly is an annuity?  It is generally described as a contract issued through an insurance company that allows money accumulation and distribution for life or some specified time period.  Unlike life insurance products where policy issue and pricing are based largely on mortality risk, annuities are primarily investment products.  Annuities may be funded with a single lump sum deposit or through a series of periodic payments.  The insurer credits the annuity fund with a certain rate of interest, which is not currently taxable to the annuitant.  The ultimate amount that is payable is, in part, a reflection of these factors.  Most annuities guarantee a death benefit payable in the event the annuitant dies before payout begins.  This death benefit is usually limited to the amount paid into the contract plus interest paid.”

  The NAIC Buyer’s Guide to Fixed Deferred Annuities states an annuity is a contract in which an insurance company makes a series of income payments at regular intervals in return for a premium paid in a lump sum or over a period of time.  They further state that only an annuity can pay an income that can be guaranteed to last for the lifetime of the annuitant (under a lifetime income annuitization income option).  The amount of life time income will, of course, depend upon the amount of money deposited into the annuity.

Making Decisions

  Americans, and really citizens around the world, have become dependent on the internet. We go to the internet for just about everything from household goods to investment products. However, it is important to realize that just about anyone can proclaim their views online; that does not necessarily mean the information is correct or even fairly stated.  While we are not advocating discontinuing the use of the internet it is important that individuals verify the information they receive.  Insurance producers may face obstacles created by the internet if prospective clients have done “research” on their own.

  Perhaps the greatest failing of the internet is that it provides an incomplete picture of investing and investment vehicles.  Yes, there is some information provided (some very good information in fact) but it is seldom complete.  There is a logical explanation for this incomplete financial picture: it would take a book to completely explain any financial investment vehicle. It simply is not possible to give a total look at a complicated financial vehicle in a few paragraphs or even a few pages of text. Generally speaking, most websites will be promoting their particular products, so the information provided may be slanted to their products.

  Unfortunately, every author, every agent, and every well-meaning next-door-neighbor claims to be an expert.  Who should the average consumer believe?  If you are the selling agent, you hope your clients believe you, but it will only take one mistake to convince your clients otherwise.

  The wise agent will carry E&O insurance: errors and omissions coverage.  Even a fully educated annuity specialist can make an error or forget to give a vital piece of information. Additionally, even if full disclosure was made, the client may claim otherwise. When it is the agent’s word against his or her client’s the outcome is uncertain. This is also a strong argument for agent documentation.  Especially if an equity indexed annuity product is presented there can be consumer confusion and poor choices can have adverse consequences.  Even when principal is preserved a client who receives zero growth may become unhappy.

  The first step is always to realize that although fixed rate annuities are an excellent and relatively safe investment that still does not make them right for every person and every situation. The length of annuity maturity and the age of the investor are of great importance.  Annuities are designed to be long-term investments so they are seldom a wise choice for short-term goals.  The Internal Revenue Service considers annuities a retirement vehicle so they will impose a 10 percent penalty on withdrawals made prior to age 59½ (it is an early withdrawal penalty).

  There are important differences between annuity products that must be considered when selecting a suitable annuity investment.  Variable annuities are classified as securities just as stocks, bonds and mutual funds are.  Although underwritten by insurance companies, variable annuities are offered through securities licensed registered representatives.  Simply having an insurance license does not necessarily allow the agent to market variable annuities.  They do not give the same safety, security and guarantees fixed rate annuities offer. Equity indexed annuities are not variable annuities; they are a more complicated form of traditional fixed rate annuities.

Annuities Have Many Uses

  Most people having financial independence will benefit from purchasing some type of annuity, many professionals feel it makes sense to have both variable and fixed rate products, but this is always a personal choice.

Safety of Investment

  There are many reasons fixed annuities offer safety of investment, but one of the reasons has to do with capital reserve issues.  Our government gave money to maintain many of the banks following their poor lending practices and resulting money problems.  Most experts felt it was necessary to ease the credit markets so our society could move forward.  In most cases, the banks did not begin loaning again, as was desired, but instead used taxpayer money to improve or maintain their own capital reserve requirements.

  Insurance companies have the same capital reserve requirements as banks but fixed rate annuities must reserve the capital required to meet their financial obligations, which are contractually guaranteed to protect their policy holders.  These reserves cover not only the rate guarantees but also minimum guarantees, income guarantees and living benefit guarantees.  As a result, investors should not only be looking at potential lifetime income, but also at the safety of principal annuities offer.

Funding Retirement

  Although annuity funds may be used for any reason, retirement is a primary use.  Annuities are tax deferred vehicles, so by depositing over a long period of time they are an excellent method of acquiring funds for retirement.  Taxes will be due when funds are withdrawn, but annuitants can time those withdrawals with their current tax situation, thus minimizing taxes as much as possible. IRS will penalize early withdrawals, so annuitants should wait until age 59½ to access their retirement funds, but since most people do not retire prior to age 60 it works out well.

  Accessing the funds during retirement may be accomplished through annuitization or by simply withdrawing funds periodically. If annuitization is selected it is extremely important to understand the various options. If maximization of funds is the goal the policy owner is likely to take a lifetime income option, but if there is also concern for the beneficiaries, this may not be a good choice.  Agents must carefully explain all options prior to the annuitant’s selection.

Structured Settlements

  Annuities are often the financial vehicle of choice for structured settlements.  These are often mandated by courts, but need not be.  Usually it is court ordered or agreed to by two or more parties and then accepted by a presiding judge.

  A structured settlement is a settlement amount that is structured to pay a specified sum over a specified time period or lifetime of an individual.  Annuities are typically used to guarantee that the payments will be made as agreed upon.  They take the payment out of the hands of the liable party and place it with a legally-disinterested third party.  The amount of payment will depend upon the settlement amount placed with the insurer and the expected lifespan of the annuitant. Usually the court is not concerned with the amount of periodic payment but rather with the total of principal deposited in the annuity since it is that premium that represents the legal settlement.

  Insurance companies know how to analyze risk; it is part of their job and they do it every day.  Not all insurers offer identical payouts derived from the same amount of principal however.  Some companies may charge more for their overhead or there may be other conditions that affect annuity payouts, including the amount of credited interest.  Agents are wise to represent more than one annuity company so he or she can compare rates and payout to give their clients the best opportunity possible.

  Agents must constantly check facts and figures since annuity companies can and do change how they formulate payout amounts on newly annuitized contracts.  Previously annuitized contracts would seldom, if ever, be affected by changes.  Once a product is annuitized, the payout amount and conditions become contractual.

Beneficiary Designated Money

  Surprisingly a large number of annuities are never annuitized or used by the contract owners so beneficiaries eventually end up with the money deposited into the contracts.  It is possible that the goal was always to provide funds for the policy’s listed beneficiaries or it is possible that the contract owners simply did not require the funds during their lifetimes.

Avoiding Probate

  Annuities bypass probate procedures (although annuity values must still be listed during probate for taxation purposes).  Most people are not wealthy enough for probate to be a severe issue, but if the investor believes probate may become slow or cumbersome, annuities may be a good investment choice.  Since they have a beneficiary designation, they go directly to the person or people named in the policy.  The same is true for life insurance policies.  Any type of vehicle that has beneficiary designations may be able to pass the assets on to the named individuals outside of probate.

  Since individuals have individual circumstances, it is very important that an attorney be consulted.  In many cases, both an attorney and a tax specialist should be part of the decision making process.  There are many mistakes that can be made in the attempt to protect assets; whatever it costs to involve these individuals may be well worth the cost.

Old Money versus New Money Rates of Interest

  There is often a difference between annuity old money and new money rates.  It may depend upon multiple factors including current investments available to the issuing insurer.  Newly issued policies may earn more or less than previously issued contracts.  Some new contracts offer higher rates to be competitive if other insurers have come out with better contracts than previously offered.  Like all types of businesses, insurers must attract new clients as well, so higher rates on new money may be a way of gaining new policyholders.

Annuity Participants

  There are four annuity participants: the annuitant, the contract owner, the listed policy beneficiaries, and the issuing insurance company.

  The annuity owner and the annuitant are often the same person.  The owner is the individual who owns the “rights” to the annuity income.  The annuitant is the person whose life is measured by the annuity.  In a life insurance policy, he or she would be called the insured but in an annuity product the measuring life is called the annuitant.

  Annuities offer the opportunity to list beneficiaries.  If the contract is not annuitized, or if it is annuitized in a manner that allows unused funds to go to a listed beneficiary, the person or persons listed will receive funds after the contract owner’s death.

  The issuing insurance company is, of course, the insurer that underwrote the policy, accepted the risk, and issued the contract.

Types of Annuities

  Although annuities are issued by life insurance companies, they do not insure against premature death as a life insurance policy would.  Annuities do have beneficiary designations but their intent is not to provide money for heirs; the intent is to provide income during the life of the contract owner.

  As we continue to live longer, we are justified in fearing we might run out of money before we run out of life.  In other words, Americans are at risk of having too little money set aside for the last years of their life.  As we continue to have smaller families, we may not be able to count on our children to care for us both physically and financially in our last years.  A major cost to our Medicaid system is the increasing use of nursing homes by people who have depleted their own savings.  As our senior Americans spend all they have, they must turn to Medicaid for their health care needs.  Few people are saving adequately for their retirement years so annuities, with lifetime annuitization options, make good sense.

  Contract maturity varies by annuity, but most require several years to mature.  Surrender penalties can be anywhere from 12 months to ten years or even longer.  When surrender penalties end the contract has reached the contract’s term.  Withdrawals made prior to term might be subject to insurer penalties, unless a provision allows partial withdrawals.  Many contracts allow the interest earnings or 10 percent of values to be withdrawn without incurring penalties.  Some annuities reward investors with bonus interest points if they do not withdraw funds within specified guidelines.

Categorizing Annuities

  Annuities may be categorized in various ways, depending upon the source used and the context intended.  However, they are typically categorized in one of three ways:

• Fixed or Variable;
• Immediate or Deferred; and
• Flexible or Single premium.

  The first, fixed or variable, will affect the security of the investment since fixed products are always more secure from a risk standpoint than variable.

  The second, immediate or deferred, describes when income is desired.  Immediate products immediately produce income while the second choice defers income.

The third, flexible or single premium refers to the ability to deposit additional money later on (after the investment was first purchased).

Benefit Payment

Immediate Annuities

  Individuals who receive a lump sum settlement or who have other sources of accumulated savings often chose to purchase an immediate annuity.  It is called an “immediate” annuity because the buyer immediately begins to receive income from the investment vehicle.  For example, Ruby has a certificate of deposit at her local bank that she wants to convert into continual lifetime income or income for a specified number of years (this depends upon the payout option Ruby selects).  She withdraws the funds from her bank’s CD and buys an immediate annuity from her local insurance agent.  The amount of income Ruby receives would, of course, depend upon the amount she puts into the annuity.  The insurance company uses specific tables to determine the amount they will pay Ruby each month (she could have selected other payout time periods, such as quarterly).  The insurer determines that, based on Ruby’s expected longevity, she can receive $450 each month for her lifetime.  Ruby could have received a higher monthly income if she selected a different payment option, but it would not have lasted for her lifetime – it would only pay based on the number of years she selected.  Ruby chose lifetime income because that was her goal when she chose to buy an annuity.  She will receive $450 each month no matter how long she lives, even beyond what her annuity purchase price, plus interest, actually paid for.  If Ruby lives a very long time she could come out thousands of dollars ahead.  On the other hand, if Ruby dies prematurely the insurer will keep any unpaid funds since lifetime income options do not pay beneficiaries any left over funds.

Deferred Annuities

  Deferred annuities may receive funds in any annuitization manner offered by the issuing insurer, including lifetime income or income for a specified period of time.  Although deferred annuities may be used by anyone, they are commonly used by individuals who need to accumulate funds for use at a later date.  Individuals deposit premium payments over a period of time, often many years.  At some point they will have accumulated enough funds in their annuity to fund a specified event, usually retirement.  Deferred annuities are likely one of the most common annuities since so many investors need to accumulate a pool of money to fund their retirement.  This is especially true today with the decline in company-sponsored pension plans.

Split Annuities

  Split annuities are considered tax efficient since they combine two different types of annuities: a single premium deferred annuity and a single premium immediate annuity.  “Single premium” means one premium payment is made into each annuity versus multiple payments over a period of time.

  One annuity pays the investor a set sum of money each and every month over a specified period of time.  As in Ruby’s case, the length of payments will depend upon the payout method selected by the investor upon annuitization of the annuity.  The other annuity is left in place to grow on a fixed interest basis.  The goal is to maximize the length of time funds will be paid back to the investor.  By the time the funds in the investor’s immediate annuity are depleted, the single premium deferred annuity will be restored to the investor’s original starting principal.  This allows him or her to then restart the process with new prevailing interest rates.  Prevailing interest rates will hopefully be higher than they would have been when the first annuity was annuitized.  Of course, there is no guarantee of that; historically rates rise, but recently that has not been the case.

Payment Methods

Single Premium Annuities

  Single premium annuities are annuities purchased with a single premium payment, thus the name.  These are often used when funds are being transferred from another type of investment vehicle, such as Certificates of Deposit.

Flexible Premium Annuities

  Flexible premium annuities allow the investor to save over a period of time, often many years.  “Flexible” means premium deposits are flexible allowing a young family to make premium payments either systematically, such as through payroll deductions, or as they find those elusive extra dollars.  As previously stated, systematic saving into an annuity is likely better than depositing here and there, as able, but any amount of saving is better than none at all.

  The contracts sold by insurance companies will offer different options; not all allow any amount to be deposited for example.  In most cases, there is a minimum amount that can be deposited into a flexible premium annuity, such as no less than $50 per premium payment.  Some contracts may require systematic deposits if the premium amounts are low.  Most contracts allow premium payments to be monthly, quarterly, semi annually or annually throughout the life of the policy holder, or for 2 or more people.  Contracts can also be for a predetermined time period.  In all cases, it is important for the investor to select an annuity contract that suits their needs and saving abilities.

  Flexible premium deferred annuities often accept ongoing small deposits as low as $50 per month.  The interest rate guarantee period on each deposit is for one year; at the end of the guarantee period the depositor can benefit from competitive renewal rates, which are based on current market conditions.

  Each type of annuity is an advantage for some investors, based on their goals.  A primary advantage of flexible premium annuities (all annuities really) is the principal guarantee they offer; investors will not have to worry about losing their principal no matter what the general economy is experiencing.  Annuities are considered conservative investments; they may not experience the growth that stocks might for example, but the guarantees of principal have become very important in recent years.

Annuity Type Based on Policyowner Risk

  There is absolutely no investment without some type of risk, even if that risk is due to inflation.  If the earning ability of the investment is too small, then inflation will not only erase the interest earnings but also the buying power of the principal itself.  Having said that, there are other more identifiable risks in many investments.

  Each investor has what is commonly referred to as “risk tolerance.”  This means the ability of the investor to accept the risks of the investment – and there are always risks.  Some investors enjoy risk; there is something exciting in the possibility of making big returns and the risk that accompanies this excitement is not a deterrent for these individuals.  As investors age, however, risk is seldom wise.  A young investor has time on their side; if they lose big, they have time to make up their losses.  An older person does not have time on their side.  Older investors should always seek safety rather than excessive risk.

  Some types of annuities have more risk than other types.  The riskiest annuity is the variable annuity; return is variable – not guaranteed.

Variable Annuities

  Variable annuities are issued through insurance companies, just as other annuities are, but they are not like other annuities.  There is no doubt that variable annuities involve investment risk and are not suitable for all investors.  Between fixed annuities, equity-indexed annuities and variable annuities, variable annuities pose the highest degree of investment risk.

  Variable annuities get their name from the fact that the rate of interest earned is variable, dependent upon the market index the contract is based on.  The money deposited in a variable annuity is tagged with a portfolio of investments that earn based on what the market is doing.  Generally speaking, the risk in these annuities is at the maximum, just as stocks might be.

  Variable annuities are complex (often described as mutual funds wrapped in an insurance policy).  Variable annuities may be purchased as an immediate product or as a deferred contract.  In other words, a single premium may be made or multiple premiums over a period of time.

  Variable annuities offer a range of investment options, all of which contain investment risk.  Like most annuity products, variable annuities are designed to be held for several years; they are long-term investments.  Variable annuities have surrender fees, as do most annuities that may last as long as ten years or more.  Many investment professionals feel the insurer surrender penalties are not as worrisome, however, as the many other fees that might be in these products.  That is because the surrender fees are clearly stated whereas some underlying fees may not be.  For example, there may be underlying fund expenses that are imposed by the underlying mutual funds investment.  These are often indirectly paid by the investors making it difficult to understand their investment impact.

Fixed Annuities

  Both immediate annuities and deferred annuities are fixed annuities.  A fixed annuity earns its name from the “fixed” aspect of the contract.  It ensures a fixed rate of return on the investor’s money.  The rate may be less if compared to other types of annuities but this form of annuity is the safest from a risk standpoint.  Even during the saving period the annuity earns the fixed rate of interest.  Therefore, the amount of money that is with the insurance provider keeps growing at the fixed rate of interest stated in the annuity contract.  Fixed annuities have less investment risk than fixed equity-indexed annuities.

  Annuities are tax deferred vehicles, but taxes will eventually be paid.  Interest earnings in non-qualified contracts will be taxed in the year in which they are withdrawn.

Declared Rate Fixed Annuities

  As we know, the principal in a fixed rate annuity is guaranteed but in declared rate fixed annuities the interest earnings may also have a guarantee.  It may not necessarily be labeled as a declared rate fixed annuity but the declared rate of interest will be posted in the contract or on an attachment to the contract.  The declared rate of interest earnings is typically connected to the length of annuity commitment in some way.  For example a ten year surrender term is likely to promise a higher rate of return than would a five year surrender term product.

  The contract will have a minimum guaranteed rate but many contracts will also have a currently paid rate of interest that is higher than the minimum guaranteed rate (depending on current markets of course).

Indexed Fixed Annuities

  An equity indexed annuity is first and foremost an annuity product.  Unfortunately, indexed annuities are often thought to be a form of variable annuity, which they are not.  Rather equity-indexed annuities are a type of fixed annuity product.  For this reason equity indexed annuities are sometimes referred to as fixed equity-indexed annuities.  They may be one of the best retirement tools developed in recent years, especially considering how the stock market has recently performed.  EIAs typically guarantee at least one year of initial premiums returned if the product is held past the surrender period.  Since the indexed annuities have a link to a major stock index, there is the potential of growing faster than a traditional fixed annuity product.  However, their complexity means they are not for all investors.  Any person who does not fully and completely understand how the product works should neither sell equity indexed annuities nor buy them.

  An equity indexed fixed annuity will experience variable returns because the annuity is linked to a market index but it is not a variable annuity even though the earnings are variable.  They are certainly more secure than variable annuities but they are also very complex. Equity indexed annuities (called EIAs) are not regulated as securities even though they are linked to the stock market index.  This means they are not regulated by either the Securities and Exchange Commission (SEC) or the National Association of Securities Dealers (NASD).  As a result, salespeople are not required to have a securities license as is the case with variable annuities. 

Two-Tiered Annuities

  A two-tiered annuity is another method of creating interest. Many professionals consider them a poor use of annuities since they can be misleading. Some states have even outlawed them.

  In 2008 the National Association of Insurance Commissioners defined two-tiered annuities as an annuity with two separate and independent values, usually called the annuitization value and the cash value.  These values are calculated separately and frequently become further apart over time.  In contrast, over time account values and cash values of a single-tier annuity becomes closer together rather than further apart.

  The tier-one value is the value of the annuity bearing interest.  The earnings are growing on a tax-deferred basis and it works just like a fixed annuity.  The client will receive the full accumulated value of the annuity contract after the contract surrender term has been completed or when the contract is annuitized and placed on systematic payout.

  The tier-two value is the cash that can be withdrawn by the contract owner.  The cash value balance earns a minimal rate of interest that is set by the insurer.  This rate of interest is less than that credited in the tier-one portion of the contract.  Typically on a two-tiered annuity only the annuitization value will be credited with any bonuses and index gain that the investor receives.  Therefore, withdrawals greatly damage the total value of the product.

  The surrender value only comes into play if the client decides to surrender the policy earlier than the intended time period.  The surrender value is the contract value minus the surrender charge and may include the market value adjustment which will give the net surrender value.

  These products are not suitable for many investors, including those with short-term goals.  Investors may have to wait a long time to access the tier two values outside of annuitization so in a way, these products require annuitization.

  Clients should make sure that these types of annuities are suitable for their situation. These annuities are not suitable of everyone and agents should make sure their clients understand the different values of the contracts prior to purchasing a two-tier annuity.

  The two-tiered approach credits the contract with a lower rate of interest if a partial or total surrender is made.  Sometimes this is true for a specified time period; sometimes it is true for the life of the policy.  They often have substantial charges for withdrawals, a charge that may never disappear, depending upon contract terms.  Accounts may be credited with an artificially low rate if a minimal payout period is selected by the policy owner.  Investors may believe they are receiving a competitive rate of interest when, in fact, they are not due to charges in the contract.

Fixed Rate Annuities

  Fixed rate annuities are the opposite of variable annuities; the rate of return and payout is “fixed”, not “variable.”  The traditional fixed rate annuity is very easy to understand, which is probably one reason so many consumers buy them.  Investors deposit money, the funds earn interest, and upon retirement benefits are paid out.  Equity indexed fixed rate annuities are not as simple as traditional fixed rate annuities however.

  All fixed rate annuities typically have the following features:

· A guaranteed amount at the end of a specific time period;

· A free bailout option;

· The ability to add new contracts;

· Ability to know the financial future of the product, and

· Tax benefited annuitization.

  The guarantees of a fixed annuity are guaranteed every day; investors often choose annuities for that reason.  At the end of a specified period of time the investor is guaranteed to have the amount of earnings stated in their contract.  Fixed rate annuities are conservative investments but also safe investments.

  When an individual decides to invest in a fixed rate annuity a specified minimum guaranteed rate of return becomes contractual.  The contract might pay more than the minimum guaranteed rate, but it will never pay less.  Normally, the longer an investor is willing to commit, the higher the rate will be.

  Whatever length of time the investor commits to, the minimum rate of return is guaranteed in the contract.  If the person chose a nine year option at 3.33 percent, he or she would be guaranteed 3.33 percent for the length of the contract, whether or not other aspects of the economy go up or down.  Actual rates will vary from company to company and even among annuity products with the same insurance company.  Normally the minimum rates offered by annuity contracts are higher than those offered by Certificates of Deposit or money market accounts.  Annuities may pay a higher interest rate each year than the stated minimum guaranteed percentage rate, but they will never pay less than the stated rate.

  Annuities are often used with retirement income in mind.  Since there are insurer penalties for early withdrawals during the surrender penalty phase, investors must decide how long to tie up their money.  Some financial advisors feel the answer depends on what one believes will happen to interest rates in the future.  If the investor believes rates will go up during the next several years, he or she may want to choose a shorter annuity contract.  At the end of the surrender penalty phase, the investor could roll their annuity into a higher rate contract, whether they stay with that company's annuity or switch to another company’s.  However, if the investor believes interest rates are going to fall, they may choose an annuity that offers the longest possible term (perhaps ten years).  If the person is uncertain about the direction of the interest rates, they can opt for a term in the middle.  Statistically, many annuities are never annuitized.  Often funds are not used by the investor so in the end, they go to the designated beneficiaries.  With the changes in the economy, this past trend may reverse.  Today fewer retirees have sufficient monthly income so they are more likely to access their annuities.  Our parents and grandparents often had employer sponsored retirement plans that provided adequate income during retirement.  Additionally, our parents and grandparents were less likely to spend at the levels current retirees do.  They were less likely to travel, buy memberships to country clubs, or move into retirement communities.  Today’s retirees spend much more freely than our parents or grandparents did.  As a result, most economists believe annuity products will be accessed by today’s retirees, even though this was not true in the past.

  The free bailout option is closely tied to the guaranteed interest rate provision of a fixed rate annuity.  This can be very advantageous to the investor (contract owner).  If, after the guaranteed interest rate period is over the renewal rate is ever less than one percent of the previously offered rate, the investor can liquidate all or part of the annuity - principal and interest - without cost, fee or penalty.  This gives the investor the security that he or she will always be receiving a competitive rate.  If the investor wants to change, and the renewal interest rate is not less than one percent of the previously offered rate, the insurance company may charge a back-end penalty.

  Normally if a person wants to add to their annuity contract, they must purchase another annuity contract.  The fixed rate annuity is a contractual relationship.  The insurance company is guaranteeing a minimum rate of return on the specific invested amount.  Only a few insurance companies allow a person to add to an existing annuity contract.

  The fixed rate annuity always allows the investor to know where he or she stands, so the future of the investment is always known.  Investors know the exact amount of money that will be available at the end of the specified period.  The annuity contract will spell out what a person can expect in the way of principal growth.  Any penalties or fees that may exist will be specifically stated as well as the point they disappear, if applicable.

Annuitization provides an even distribution of both principal and interest over a period of time.  The amount of each check can depend on:

· The competitiveness of the insurance company,

· The level of current interest rates,

· The amount of principal that is to be annuitized, and

· The duration of the withdrawals.

  When an investor decides to annuitize, the amount of each check on a fixed rate annuity will depend on the current interest rates.  Under some contracts, the contract owner can decide to annuitize only a portion of the contract so that some of the investment left invested is still earning interest.  Obviously, the amount of the check received depends on the amount of the investment annuitized.  The larger the investment is, the larger the check received will be.

  The time allotted to the annuitization will affect the size of the monthly or quarterly income received; the check will be larger if a shorter annuitization period is selected (such as ten years versus 20 years).  Lifetime income options eliminate beneficiary designations, so that must also be taken into consideration.

  Fixed rate annuities are among the safest and most conservative investments.  People holding Certificates of Deposit often select fixed rate annuities to obtain additional advantages not offered by CDs.  Since both are extremely safe, those who favor Certificates of Deposit are also likely to favor the traditional fixed rate annuities, but not necessarily fixed equity indexed annuity products since they are more complicated.

Equity Indexed Annuities

  Most equity-indexed annuities are declared rate fixed annuities, meaning the annuity’s rate of interest is re-set each anniversary date.  For example, the first year might guarantee an interest rate of no less than 3 percent; the second year could adjust down or up, depending on current markets.  Whatever subsequent years might be, the declared interest rate can never be a negative number.  Like all annuities, as long as the investor holds the product to maturity, he or she will receive at least all they paid in; the investor will never lose principal, as can happen in stocks and mutual funds.  For many investors, the absolute guarantee of principal is the major reason annuities are chosen for retirement investing.  This might especially be true for those with past experience in the stock market.

  While annuity contracts are not all the same, generally EIAs do not have internal expenses, meaning there are no fees, or front-end or back-end loads that could retard the product’s performance.  While we must always stress that contracts can and often do vary, most equity indexed annuities have clarity in that what is presented by the insurer is what is actually charged.  This is different than variable annuities, mutual funds, and managed accounts that typically have various management fees and expenses.

  Typically, equity-indexed annuities are deferred annuity vehicles because they do not begin providing income for several years.  An annuity that begins paying income within a year of contract origin is considered an immediate annuity.  The insurance companies need a period of time to earn a profit and the annuity needs a period of time to earn enough interest to adequately perform.  The period of time during which the annuity is growing, earning interest, and perhaps receiving additional deposits from the investor is called the accumulation phase.  Once systematic payments begin (upon annuitization), the contract moves into the distribution phase.

  Equity-indexed annuities often allow free withdrawals during the accumulation phase without charging surrender penalties, but it is always necessary to read the contract for details.  Depending on the contract, it may be possible to withdraw up to 10 percent of the account value during the accumulation phase.  However, it is important that contract owners realize that any time funds are withdrawn there is less money in the account earning interest.  Even so, this can help with occasional financial needs of the investor.  If the investor is not yet age 59½ any withdrawals are probably subject to the 10% Internal Revenue Service early withdrawal penalty.

  Once the distribution phase begins, the annuity’s account value will be declining steadily, as monthly or quarterly payments are made.  Investors typically take distribution payments monthly or quarterly, but many contracts allow semi-annual or even annual payments through the annuitization process.

  What we have been discussing is true of all fixed rate annuities so why would an indexed annuity be better than any other fixed rate annuity?  If the stock market crashed or simply underperformed the equity-indexed annuity, like other fixed rate annuities, would simply continue to operate as they always do, paying the pre-set rate of interest on the investment exactly as the contract promises.  However, with an indexed annuity, if the stock market is performing well, the fixed equity-indexed annuity will earn more than a traditional fixed rate annuity would.

  All EIAs track some specified stock market index; commonly it is Standard & Poor’s index of the stock values in 500 of the largest corporations known as the S&P 500.  The S&P 500 is a registered trademark of McGraw-Hill & Company.  Whatever index is used if it substantially increases during the term of the equity-indexed annuity, the annuity’s value will increase to the extent specified in the annuity contract.  It would be unusual for the equity-indexed annuity to grow exactly as the index it is based upon grows.  Most do not tract the index exactly and there are various methods used to correlate gains.  It should surprise no one that some contracts are more generous to the investor than others.  It is important to realize that this added value should be considered a “bonus” since there is no loss if the markets perform poorly.  No investor should buy with the expectation that there will always be bonus earnings either.  EIAs are first and foremost a fixed annuity product, but there may be additional earnings if the markets are favorable.

  While it may not be so prevalent today, at least initially, equity-indexed annuities were constantly compared to variable annuities.  They are not and never were variable annuities.  Critics of equity-indexed annuities may still try to compare them and that does a disservice to the product.  More importantly, it confuses investors.

  A variable annuity tracks the stock market directly so its values go up and down with the stock market.  That is not the case with an equity-indexed annuity.  Just like all fixed rate annuities they perform based on the contract with a bonus earning if the index it is based upon performs favorably.  Variable annuity values are determined by a separate account that holds various investments, often similar to mutual funds, for each contract owner.  Many allow contract owners to choose their own funds but in most cases it is important that the portfolio be well managed for maximum performance.  Variable annuities experience full stock market risk while equity-indexed annuities do not.  This distinction should not be taken lightly since it is a tremendous difference in product types.  Just as stock market managers are unable to provide long-term financial guarantees variable annuities cannot give long term performance guarantees either.  Experienced money managers may be able to forecast but it is just that: a forecast – not a guarantee.  Some variable annuities do guarantee the investor’s return of principal in the case of premature death or during a specified time following the contract’s issue date.  A variable annuity has the potential of total loss; that is, the investor could lose the entire amount he or she invested if the market takes a dive and remains down.  A fixed equity indexed annuity would not be affected by a market dive; the investor simply would not earn any “bonus” earnings.  As long as the investor holds the annuity contract past the surrender period (maturity date) he or she would receive all principal sums and any guaranteed interest earnings.

  Another important difference between variable annuities and fixed equity-indexed annuities are the fees charged.  While every contract can vary, typically variable annuities have several types of fees and expenses, many of which are tied to the buying and selling of stocks.  Obviously, fees and expenses (often referred to in the contracts as management fees) will retard potential earnings.  Equity-indexed annuities generally do not have internal fees and expenses beyond what is prominently stated in the contract.  Any fees that do exist would be minimal so the investor knows exactly what his or her contract earnings are.

Variable Annuities

  Variable annuities present the most risk among annuity types but they also offer many investment opportunities.  A variable annuity is (1) an investment company, (2) an entity that makes investments and (3) institutions that share common financial goals.

  A variable annuity is basically a tax-deferred investment vehicle that comes with an insurance contract designed to protect the investor from a loss in capital.  Thanks to the insurance involvement, earnings inside the annuity grow tax-deferred and the account is not subject to annual contribution limits.  In a variable annuity the investor chooses from among a range of different investment options, typically mutual funds.  The rate of return on the purchase payments, and the amount of the periodic payments eventually received will vary depending on the performance of the investment options the annuitant selected.

  Generally, the investor chooses from a menu of mutual funds, known as “subaccounts.”  Withdrawals made after age 59½ are taxed as income.  Like most annuities, earlier withdrawals are subject to tax and a 10% IRS penalty.

  Variable annuities can be either immediate or deferred.  With a deferred annuity the account grows until the investor chooses to begin withdrawals, which should be after age 59½ to avoid IRS penalties.  The annuity may be annuitized, using one of the payout options, or the investor can withdraw money as he or she wishes (never annuitizing the contract).

  Like most annuities, variable annuities are long term investments.  The longer the policy owner allows their money to build, the more he or she is likely to gain from the investment.  However, unlike fixed annuities (where the funds sit in an account from which payments provide a fixed income throughout a fixed time period), variable annuities give the investor more control over their investment but also gives the investor the burden of risk.  There should be no mistake on this point – variable annuities have investment risk.

  The money deposited into variable annuities can go into the investor’s own account, separate from the investment portfolio of their broker or insurance company. The investment choices are, therefore, the investors to make.

  As one nears retirement, it often wise to avoid riskier investments since the time to make up losses is not there.  Younger investors are more likely to favor variable products since they do have time on their side and they may actually enjoy involving themselves in the investment choices.  These investors may want to play the money market, or invest in stocks, bonds, or equity funds.  The variable annuity returns depend on the account's performance rather than just rising and falling with the fortunes of the firm that holds it.

  Variable annuities often provide a wider spectrum of investment opportunities for retirement savings, while providing professionally managed fund options as well.

Annual Expenses

  The investor’s broker or insurance company may guarantee the principal investment, minus withdrawals for any of the following annual expenses.

• Annual annuity charge.  This fee is based on the total value of the variable annuity, plus the cost for the broker or insurer administering it and giving the investor the option of a lifetime's worth of annuity income.  When the contract with the annuity broker provides for death benefits, annual annuity charges increase.  This is generally computed by adding M&E (mortality and expense risk) to administration charges.
• Maintenance fee.  This is simply a yearly fee for maintaining the contract. It pays for contract administration and communication services.
• Underlying fund fees.  The broker holding the variable annuity will normally charge an annual fee for managing the investments.
• Surrender charges.  If the investor withdraws any portion of the money within the first years of his or her variable annuity, he or she must pay surrender charges based on a declining scale.

  Agents should never assume that the percentages or costs we have listed apply to all annuity products.  Companies continue to change, add, or delete features as they try to gain additional clients, market shares, or correct faults within the products.  Always read and understand the product being sold.

Funding Variable Annuities

  Investors should first maximize their retirement options as far as their individual retirement accounts (IRA) or employer-sponsored programs are concerned.  If the investor has the ability to invest additional funds towards their retirement, then a variable annuity could be a good option.  Since this is a risk vehicle, few professionals would recommend it as the only retirement investment.

  It is possible to either purchase a variable annuity outright or make regular deposits to it over time.  The investor usually has the option of trading any current annuity for a variable annuity.  However, transferring funds from an already tax-deferred plan, such as a 401(k) plan, into a variable annuity will not add value to the investment since the investor would just be paying their broker fees for tax deferral they already have.

  Popularity is no indicator of practicality.  Not everyone needs an annuity and certainly not everyone should buy a variable annuity due to the risk involved.

  Variable annuities do have fees.  Some financial planners feel the amount of fees are extravagant in some variable annuity products, so the wise agent will certainly shop around for the products they want to represent.

Variable Annuity Death Benefit

  The variable annuity death benefit basically guarantees the account will hold a certain value should the annuitant die prior to annuity payments beginning.  With basic accounts, this typically means the beneficiary will at least receive the total amount invested even if the account has lost money.  For an added fee this figure can be periodically increased.  If the investor decides not to annuitize the death benefit typically expires at a specified age, often around 75 years old.

Contract Provisions Affect Consumers

  Whether the investment is gold or pork bellies, the investment performance will affect investor earnings.  The same is true of annuities.  Obviously, the primary way the investor is affected is by the amount of return or loss of principal but there are other effects as well.

  For example, Connie and Robert want to buy a house.  Their Uncle Charlie tells them to buy an annuity because the gains are tax deferred.  Uncle Charlie is retired and only knows how his annuity worked for him.  He does not realize that there is an IRS early withdrawal penalty or that companies impose surrender charges if the annuity is not kept to maturity.  Hopefully Connie and Robert will discover this before they make a buying error.

  Any investment considered by a consumer must meet their needs and goals.  Just because a product suited one person perfectly is no guarantee that it will suit the next person just as well.  Annuities have variations that work for some but not for others.

  Traditional fixed rate annuities are typically suitable for the investor who is risk adverse and wants guarantees in writing.  Equity indexed annuities (which are fixed rate products) allow greater growth potential but they often do not guarantee growth.  While principal may be guaranteed it is possible that there will be no interest earnings, depending upon the market performance.  On the other hand, they may earn higher rates than the traditional annuity – again depending upon market trends.

  Variable annuities are suitable for investors who do not mind risk; some investors seek out risk because they have a high risk tolerance and they hope to make greater gains than possible in the more conservative annuity contracts.

Annuity Surrender Values and Penalties

  Annuities have surrender penalties.  The policy will state the terms of the surrender periods.  This is an important part of the contract and should not be minimized.

  Some contracts may refer to surrender penalties as withdrawal penalties, but whatever the term annuities will penalize the annuity owner for early withdrawals.  It may be possible to take 10% withdrawals without penalty; refer to the annuity contract for details.  Certainly if the owner removes the full contract value before maturity there will be a penalty based on how long the contract has been held.

  It would be unusual to see an annuity contract that did not have surrender fees.  The length of the fees will vary, with seven to nine years being common.  The reason insurers can guarantee interest rates is because they expect to have the funds for a specified period of time.  To discourage early withdrawal of funds or a complete surrender of the contract insurance companies impose early surrender fees.  Surrender fees are a type of penalty for withdrawing money sooner than agreed upon at the time the contract was issued.

  Surrender charges start off high and decrease a percentage point each year. For example, in a nine year contract, the first year would experience a nine or ten percent penalty fee, and then decrease by one percentage point each year.  It might look like the following:

Contract Year 1	9% surrender fee
Contract Year 2	8% surrender fee
Contract Year 3	7% surrender fee
Contract Year 4	6% surrender fee
Contract Year 5	5% surrender fee
Contract Year 6	4% surrender fee
Contract Year 7	3% surrender fee
Contract Year 8	2% surrender fee
Contract Year 9	1% surrender fee
Contract Year 10	Zero surrender fee

  When there is no longer a contract surrender fee the policy has reached what is called the term of the policy.  Some people refer to this as policy maturity, but actual maturity is not the end of the surrender period; it is the latest date on which the owner can begin receiving payments from the annuity.  Most contracts state a specific age for maturity, such as age 100.

  Surrender penalties or fees do not apply if the contract is annuitized or when death benefits are paid due to the annuitant’s death.  If the contract is annuitized, an income stream begins and the contract is then “locked in” based on the payout option selected.  Once a payout option is selected and the first check has been cashed it is generally too late to make any changes; the contract owner cannot change their mind later on.  Whatever payout option was chosen determined length and amounts of systematic income.

  Annuity critics seem to concentrate on commissions earned by the selling agents, an odd concern to say the least.  This is odd because the rate of commission has no direct effect on the contract terms.  As long as the investor is aware of the guaranteed rate of interest and is content with the guaranteed rate stated, whether or not the agent earns a commission has no direct effect on the product’s performance.  This is true of all fixed rate annuities, and the fixed equity-indexed annuity is no exception.

  Sometimes annuity critics argue the annuity product would pay a higher rate of return if the agent received less commission and this may be true to some extent.  However, the overall performance is stated in black-and-white for the investor to view.  If he or she is happy with the contract terms there should be no concern for the amount of commission his or her agent will receive.  The first and primary concern is simple: does the investment suit the investor’s goals and requirements, including risk tolerance?

  The commissions paid to agents may affect the bottom line since the more the insurer pays their agents (or to any other operational expense for that matter) the less there is for other insurer costs.  To this extent, commissions may affect interest rates that are guaranteed (it will not affect rates based on market performance in most cases), participation rates, caps and the length of surrender periods.  Since these terms are already set when the product is offered the investor will not get a better contract by bargaining for lower commission rates.  The investor would be wise to shop the marketplace for the best product but that is wise regardless of commissions paid.  Many critics feel agents only present products that pay higher commissions and there may be some truth to this.  That does not prevent consumers from shopping around since many available products are offered through varieties of online websites and through local agents.  Since commissions have already been built into each product commission differences may be hard to see.  It would be foolish to get so sidetracked by what agents earn that the important issues are overshadowed: safety of principal, insurer financial stability and satisfaction of investment goals.

  Many professionals advise consumers to simply find a product that fits their needs and leave commissions between the insurers and their agents.  Many elements of how insurance companies determine commissions have nothing to do with the actual product so price shopping, while always advisable, may have no bearing on what the agent receives in compensation.  Some insurers pay a higher commission for the same reason a department store pays higher salaries: they want the best people representing them.  As it applies to equity-indexed annuities, higher commissions may be paid to compete with management fees financial planners would lose if they recommended EIA products.  Financial planners stand to lose a substantial sum over the life of the EIA since he or she would have made multiple fees if they were managing a mutual fund, for example.

  Agents do have an ethical responsibility to represent and recommend suitable annuity products.  It would certainly be unethical to recommend a poor product simply because it paid a higher commission.  Many states already have or are in the process of implementing suitability requirements for annuities because there has been fear that agents might place unsuitable products, especially with older investors who do not have time on their side if a mistake is made.  Investors are always best protected by finding a career agent with product knowledge and a desire to be in business long-term.  Agents who plan to be a career agent are probably more likely to select product quality over commissions paid.  They must if they want to remain in business.

  Annuity suitability must always be considered.  Since they are long-term investments any type of annuity product must suit the needs and circumstances of the investor.  For example, most professionals would feel it was unwise to place all of an investor’s funds into an annuity (no matter how good the product is).  If he or she had an emergency need for cash there would be none available unless the investor paid an early surrender penalty on the withdrawn funds.  Therefore, agents must understand the circumstances of each investor prior to making recommendations.  Only if the investor refuses to provide full information is the agent released from his or her ethical obligation to determine product suitability.

Guaranteed Rates of Return

  Fixed rate annuities, such as equity-indexed annuities, promise a guaranteed minimum rate of return.  This may be referred to as the “floor” rate since it is the lowest rate that will be paid.  The annuity might pay a higher rate than guaranteed, but never a lower rate.  Higher rates might be paid if market conditions were good.  At each anniversary the minimum rate is re-set, but that would not mean higher rates could not be credited if circumstances warranted it.  In the case of equity-indexed annuities, there is also the possibility of bonus earnings if the market index does well.

  Investors must always pay attention to the guaranteed or floor rate since it is the only return that is promised.  Higher rates or bonus returns are not guaranteed.  Some contracts do not give more than a zero percentage guaranteed rate of return.  In these contracts, there is no guaranteed rate but the principal is still guaranteed.  In other words, in the worst index situation the investor would not lose their principal but he or she might not gain any interest earnings.  Generally fixed rate annuities (that are not equity-indexed vehicles) would guarantee at least a couple percentage points in interest but equity-indexed annuities do not necessarily do so.  This is another good reason to compare products, although the guaranteed rate of return is only one element of the product and not always the most important.  In some cases, the investor is better off with a lower guaranteed rate since the contract may offer better participation in the index-linked return if the interest rate is lower – maybe even a zero floor.  The goal is an index-linked return that out-performs the guaranteed rate of return.

  How returns are credited to the annuity contract can be important as well as the actual rate of return earned.  Some contracts may credit guaranteed interest earnings quarterly while others do not credit them until the end of the surrender period (which could be ten years from the date of issue).  If they are not credited until the end of the surrender period, then any penalty-free withdrawals will not have earned even a penny of interest.  It will be as though the funds had never been deposited.  Even if no funds are withdrawn, actual earnings are likely to be lower than a contract that deposits quarterly or even just yearly.

  Insurance companies will make early withdrawals unattractive in many cases because the point of buying annuities is for long-term investing.  Agents should never deposit money the investor may need prior to the term of the annuity contract.  Annuities, including fixed equity-indexed annuities, are not suitable for anyone who may need to make large withdrawals prior to the end of the policy surrender periods.

  Most annuity owners and annuitants do not consider how rates are determined or credited; they largely prefer to have their agents select and present an appropriate and advantageous product for them.  Crediting of participation rates can be complicated even for agents who work daily with the products.  It might prove very difficult to fully explain the process to consumers.  Despite the fact that it can be complicated, how earnings are credited can significantly affect the end results so it is an important consumer topic.

  One might assume that each company will credit all their fixed annuity products the same but that is not always true.  Even within each company, different products might credit earnings differently.

  Some products will not apply the minimum guaranteed interest rate to 100 percent of the principal.  It is possible that only 80 percent to 90 percent of the principal amount will be credited with earnings.  Some EIA contracts give the insurer flexibility to even change its crediting rates, but most contracts specify certain minimum crediting rates that must be followed.  As with all insurance matters, it is important that the selling agent be fully and completely aware of the products he or she is marketing.  It doesn’t matter how sincere the selling agent was; if a major error is made it is the agent’s fault since he or she had an ethical duty to know the products he or she represented.

Important EIA Fact:

  While most fixed annuity products guarantee against loss of premiums paid in, that is not always the case.  Some equity indexed annuities do not make this guarantee of the full amount, guaranteeing only a percentage, such as 90% plus whatever minimum interest guarantees exist.  In these cases, if the investor does not receive any index-linked interest there could be loss of premiums.  Of course, if the EIA was surrendered during the penalty period, that could also result in a loss.

In order to know how interest earnings will be credited, it is necessary to understand how the company credits premiums for the purpose of calculating interest payments.  You must also know if the issuing company has contract limitations preventing them from changing crediting methods.  So, first look to see how the insurer credits premiums and secondly, look to see if crediting methods may be changed.  This will be found in the policy.

  Every agent knows (or should know) the great difference between simple and compound interest.  Simple interest applies only to the principal payments whereas compound interest applies to both principal payments and accruing interest earnings.  In a way, that means that the interest applied in previous periods begins to act like principal, also earning additional interest.  Investors should always seek compound interest products, never simple interest policies.  In fact, a compound interest policy will often accrue more earnings even if it offers a lower rate than a simple interest product.  It will depend on the point spread, but seldom do simple interest vehicles compete well with compound products.

  According to NASD, the way an annuity company calculates interest during the policy term will certainly make a difference in the product.  Some contracts might pay simple interest during the term of the annuity but change after that point.  Anytime there is no compounding, similar rates of return will mean that the compound interest vehicle did better than the simple interest vehicle.

  Some equity indexed annuities might pay simple interest during an “index term” when bonus points are possible.  This means index-linked interest is added to the original premium amount but it does not earn compounded interest during the term.  Others may pay compound interest during a term, which means that index-linked interest that has already been credited also earns interest in the future.  In either case, the interest earned in one term is typically compounded in the next.

  Although most professionals feel it is best to stay with compound interest vehicles, there may be reasons to go with the simple interest vehicle.  Perhaps the simple interest product has some feature the investor specifically wants, such as a higher index participation rate.

  Some non-equity indexed annuities will offer bonus rates for one year, maybe even several years.  Of course, if the investor surrenders his policy during the surrender period bonus rates would not apply.  Alternately, some EIA products will offer a bonus to an older non-EIA annuity in order to draw in the business to an equity-indexed annuity product.  If the bonus makes up for any early surrender penalties it may be worthwhile, but product replacement should never be considered without knowing all the facts.

  Sometimes we may see a financial journalist suggest that any annuity bonus inducements are questionable.  It suggests the insurer has an inferior product and is using the bonus to entice in customers they would not otherwise get.  We do not generally agree with this statement, although each product must be individually considered to give an adequate answer.  Just as department stores have sales to attract customers, insurers offer bonus points to attract customers.  The cost of offering such bonus points is figured in to overhead; insurers are typically very good at analyzing profit and loss.  After all, their business is based on risk factors.  Although bonuses can give an annuity product a strong performance start, it is important to also look at any limitations on performance that might affect the final returns.  In all cases, products must comply with state and federal requirements.

  If withdrawals are made, even if there is no surrender fee applied, it is likely that the amount withdrawn will not be credited with interest, so this should always be considered prior to pulling money out of an equity-indexed annuity.  Of course, withdrawals made prior to age 59½ will incur an early distribution charge from the IRS as well.

Index Crediting

  There are various fixed equity index annuity products.  The differences can be important as they apply to crediting.

  Interest crediting provides a minimum return; index crediting provides the potential of a maximum return at the end of the term because it is measured in some specified way with the chosen index.  Although interest guarantees can be zero, it is likely that at least some amount of interest earnings may be guaranteed, even if only one percent.  If an investor was only interested in the guaranteed rate of interest earnings there would probably be no point in depositing funds into an equity indexed annuity contract; a traditional fixed annuity product would be sufficient.

  The National Association of Insurance Commissioners (NAIC) has published a buyer’s guide for equity-indexed annuities.  Although there are more elements to these products than just the potential maximum return, since consumers will be looking for products that produce greater returns, it is likely that this element is often the characteristic focused on.

  The NAIC does not endorse any company or contract; their publication is intended to help the general consumer understand equity indexed annuities so that they may make the most prudent choice for their particular circumstances.  Their publication states:

“What are equity-indexed annuities?  An equity-indexed annuity is a fixed annuity, either immediate or deferred, that earns interest or provides benefits that are linked to an external equity reference or an equity index.  The value of the index might be tied to a stock or other equity index.  One of the most commonly used indexes is Standard & Poor’s 500 Composite Stock Price Index, which is an equity index.  The value of any index varies from day to day and is not predictable.”

  Like all annuities, equity indexed annuities are insurance products and are issued by insurance companies.  The buyers of these products are not directly purchasing stocks.

  There are two very important aspects to equity indexed annuities: the indexing method and the participation rate.

  Equity indexed annuities are fixed annuities, either immediate or deferred.  They earn interest or provide benefits that are linked to an external equity reference or an equity index.  The index value will be tied to some particular index, such as stocks, often the S&P 500 Composite Stock Price Index.  This would be an equity index.  The value of any index changes often, perhaps daily or even hourly.  The changes cannot be predicted, so there is growth risk involved, although the principal is not at risk.

  The indexing method is the method used to measure the amount of change in the index.  While there is not necessarily going to be change, change is likely.  The most common indexing methods are annual reset, also called ratcheting, high-water mark, and point-to-point.  The original EIA used only a single method, usually the S&P 500.  There are now many ways to calculate contract values.

Participation Rates

  Participation rates can be a limitation on the base interest rate paid by the issuing insurance company.  They can also limit the index-linked return.  Since participation rates are primarily a function of equity indexed annuities consumers do not typically have experience with them and may lack understanding of an important product feature.

  A participation rate will determine how much the gain in the index will be when credited to the annuity.  How gains will be credited can be confusing.  The annuity company may set their participation rate at various amounts (depending upon the product); for example, it may state a participation rate at 80%, which means the annuity would only credit the owner with 80% of the gain experienced by the selected index (the S&P 500 for example).  If the calculated change in the index is 9 percent and the participation rate is 70% the index-linked interest rate would be 6.3%.  This is figured by multiplying 9% times 70%, equaling 6.3%.

  Participation rates for newly issued annuities can change daily.  As a result, initial participation rates will depend upon the date the insurance company issued the annuity.  Participation rates are usually guaranteed for a specified period of time so additional deposits may receive the same rate as the initial deposit.  When participation rates are guaranteed, they may range from one year on.  It is always important to check the actual policy since products do vary.

  Once the product period ends, the insurer will set 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.

  Participation rates offering less than full value (100%) protect the insurers in some situations and may allow them to offer higher interest rates or caps.  It may surprise consumers to learn that sometimes it is better to select products with less than full value (80% to 90% perhaps) in order to earn higher rates of interest.  Although critics may imply that less than full participation rates are a product disadvantage, in fact they are often beneficial.

  The NAIC states participation rates vary greatly from product to product and even from time to time within the same product.  It is certainly important for agents to fully understand how they work but consumers also need a basic understanding of them.  A high participation rate may be offset by other features, including simple interest, averaging, or point-to-point indexing methods.  Conversely, an annuity company may offset a lower participation rate while offering a valued feature such as an annual reset indexing method.

  An important note: some EIA contracts allow the insurer to change participation rates, cap rates, or spread/asset/margin fees either annually or at the start of the next contract term.  If an insurer subsequently lowers the participation rate or cap rate or increases the spread/asset/margin fees, returns could be adversely affected.

Averaging

  Some equity-indexed annuities average the index (called averaging) based on the indexed-linked returns during the entire period rather than simply subtracting the beginning point from the end point.  Averaging can protect consumers from index crashes or greatly fluctuating indexes.  As is always the case in averaging, the highs and lows are smoothed out.  While it does smooth out the peaks and valleys, there is the risk that some return will be lost, especially if highs outnumber lows.  Averaging methods will vary.  Some companies average daily, while others average monthly.  The National Association of Securities Dealers (NASD) mentions in their brochure titled Equity-Indexed Annuities – A Complex Choice that averaging could reduce earnings.  They also state in the brochure that a major challenge when buying an equity-indexed annuity is understanding the complicated methods used to calculate gains in the index the annuity is linked to.  Returns vary more than a traditional fixed rate annuity but not as much as a variable annuity (equity indexed annuities are not variable annuities; they are fixed annuities).  Because of the minimum guaranteed interest rates EIAs have less market risk than variable annuities.

Caps

  Some equity indexed annuities will have caps.  In other words, returns are capped or limited.  Usually caps are stated as percentages; these are the highest rates of interest that can be earned.  If the product’s index gained 9% but the cap was set at 6%, then 6% would be the most the investor could earn.  Not all equity indexed annuities will have a cap, but it is something that agents and investors must be aware of.

  Caps absolutely do affect how these products perform but that doesn’t necessarily mean investors must totally avoid them.  Annuities with caps may have other features the investor wants, such as annual interest crediting or the ability to make penalty-free withdrawals.  Caps often allow insurers to offer other benefits, such as higher interest rates.  A professional agent will help the investor to decide whether it is better for their particular situation to have higher participation rates or higher caps.

  The most common caps are annual caps and monthly caps but products vary so agents must view each contract individually.  Some contracts allow the issuing insurer to change caps based on specific market conditions.  If this is the case, investors need to be aware of the fact.

Spreads, Margins and Administrative Fees

  Some products will deduct a percentage from the gains in the form of various fees.  The percentage could be in addition to or in lieu of participation rates or caps.  The fees may come under different names, such as spread, margin or administrative fee.  These are not the only names it may come under, but they are the most common.  The fees may be in addition to or instead of a participation rate.  For example, an EIA might charge a 2% per year spread from the index-linked return.  Figuring the cost over time can be difficult or at least complicated, but over ten years, with the index performing at an average of 12% per year, there would be a 2% loss, so earnings would be 10% rather than 12%.  This is a simplification, but it does give the reader an idea of how it works.

Returns

  Equity Indexed annuities will be linked to such things as the stock market, but that does not mean returns will directly reflect a stock market purchase.  EIAs are linked to the performance of the index – not to the actual stocks that the index is based upon.  As a result, the annuity does not give credit for dividends that could have been reinvested if the actual stocks had been purchased.  The NASD states that most equity index annuities only count equity index gains from market price changes, excluding gains from dividends.  An investor that is not earning dividends will not, therefore, have the same gains he or she would have if he or she had directly invested in the stock market.  On the other hand, the investor also will not experience some of the losses that would have occurred with directly investing in the stock market.  Those who oppose investing in EIAs will point to this potential loss of growth, while those who support EIAs will point to the protection from principal risk.  The investor is trading the dividends that might have occurred for their safety of principal.  There is no investment that will be ideal.  High risk means potential high loss; low risk means less earnings.

  Most equity indexed annuities use something simple, such as the S&P 500, and do not take into account reinvested dividends.  While the loss in value of reinvestment of dividends can be significant, especially over a number of years, those who invest in these types of annuities are typically more concerned with the safety of their principal and are, therefore, willing to earn less.  Even without reinvested dividends, indexes still perform pretty well.  EIAs usually do better than certificates of deposit or bond rates, although that is certainly not guaranteed.

  It should never be assumed that every client will appreciate the benefits of equity indexed annuities, especially if higher earnings are important to them.  It is always a question of suitability and risk.  Those who want higher earnings will probably not be happy with EIAs; such investors will probably want to benefit from dividends for example.  Some advocates argue that the loss of reinvested dividends is offset by the annual reset (ratchet) annuities that credit the index return with only a zero in negative years.  However, many feel it is unwise to push any investor into any vehicle that they seem unsure of.

  There are variables in equity indexed annuities; all products are not identical.  For example, an EIA that is back-tested does not ensure financial performance.  Back-testing means that the annuity was tested against historical returns, perhaps as far back as twenty years.  Future performance will not always mimic past performance.  We have seen our markets change dramatically and they are likely to remain unpredictable.  Additionally, there is no guarantee that the back-testing is reliable since reliability is often determined by those doing the testing.

  Back-testing can help to illustrate the annuity, so it is not without merit.  However, agents and investors must remain aware that past performance does not guarantee future performance.  Professionals generally prefer the use of Monte Carlo analysis, which uses multiple samplings of random hypothetical market returns.  This may present a more accurate visualization of the product and will not leave a false impression of how the annuity is likely to perform.

Indexing Formulas

  Equity-indexed annuities credit earnings differently than other fixed rate annuities.  Where traditional annuities state a rate of interest and then apply those interest earnings at specified intervals, an EIA calculates its return against the index to which it is linked.  This is called the indexing method.  Equity-indexed annuities credit interest using a formula based on changes in the index to which the annuity is linked.  The formula decides how the additional interest, if any is earned, is calculated and credited.  With traditional fixed annuities, interest gains are always earned, although how they are credited may vary.  EIAs do not necessarily have interest gains, since they are based on the indexing method.  The indexing method, or formula, decides how the additional interest, if any, is calculated and credited.  The amounts earned, and when they are paid, depend on the contract features.

  There are multiple formulas for indexing, with new methods appearing regularly.  As a result, we will not attempt to describe indexing formulas.  New methods often are developed with the hope of attracting consumers, but in the end the amount earned is going to depend upon the performance of the index that is used.  Even professional analysts cannot accurately speculate on market performance over several years and annuities are long-term investments.

  Many investors find having multiple equity-indexed annuities, with each using a different indexing method, advantageous.  By purchasing EIAs that use different indexing methods, the investor is likely to end up with good average performance between the various annuities.  Additionally, many investors consider having multiple EIAs as a means of diversifying their annuity portfolio.  Some indexing methods work better under some conditions, and worse under others.  Diversification prevents being affected adversely with no other annuity investment to offset the adverse conditions.

  Some of the new equity-indexed annuities allow several indexing methods.  The designated indexing method on these annuities can be changed at certain times, usually on anniversary dates.  These allow consumers to select their indexing method at the time of purchase.  Some of the newer EIAs allow consumers to use several indexing methods simultaneously, allowing investors to do with one contract what usually requires several to achieve.

  Some equity-indexed annuities will allow the investor to see their progress (or lack of it) at specific times, usually annually.  These annuities have “reset” features that lock in gains on some specific basis, such as once per year so that the investor knows whether he or she gained during the year.  Generally, EIAs held to maturity do not lose principal, but that does not mean it is guaranteed to have gains.  Other equity-indexed annuities do not have the ability to see what returns are until the EIA has run its entire term, which may be many years after purchase.  Investors who want to be able to view their returns should choose a reset product.

Annual Reset Indexing Method

  For investors wishing to see their returns annually the annual reset indexing method is typically the best choice.  Annual reset EIAs usually looks at the index at the end of each contract anniversary date and locks in gains made as of that date.  This is called the annual reset method or may be referred to as the ratchet method.  Under this method the gains posted at the end of the year (or at whatever point is in the contract) will remain even if the index goes down later.  The ratchet method compares the changes in the index from the beginning to the end of the year, with declines being ignored.  The advantage is a gain that is locked in each year.  The disadvantage is the possibility of lower cap rates and participation rates that might limit the amount of available gains.

  Under annual reset methods it is possible that there will be no gains.  If the index declined from the previous year, the contract simply credits zero for that period.  In the next contract anniversary year there is then no place to go except up.  The previous period’s end value for the index (not the annuity value) is used as the starting point for the new period, meaning that each period is looked at individually.  It does not matter whether there were gains in previous contract years and will not matter in coming years what gains, if any, were given in the current year.  Although there may be lower contract cap rates and participation rates, investors choose this method for the locked-in gains, meaning current profits will not be lost to bad years that may come in the future.  Even if the stock market were to crash, any past gains are retained in the annuity values.

  Investors often do not mind the lower cap and participation rates because they feel they will be offset by the fact that negative years result in zeros rather than value losses.  While we would all like to see our investments increase in value, we also do not want to lose values.  A zero gain is better than an investment loss.

High Water Mark Indexing Method

  Another indexing method is the high water mark method.  It compares the index at various periods during the contract to the index level at the beginning of the term.  Although the time periods can vary, typically the contract’s anniversary date is the time measure used.  The high water mark indexing method takes the highest of these values and compares it to the index level at the start of the term.  While the investor may be credited with more interest under this method than other indexing methods and receive protection against declines in the index, the disadvantage is that the investor may not receive any index-link gain at all if he or she surrenders their EIA early.  That is because interest is not credited until the end of the contract term; if the contract is surrendered early, the contract term was not reached.  Some of these contracts will still give the investor interest based on the highest anniversary value to date under a vesting schedule.  Some high water mark indexing contracts might impose lower cap rates and participation rates.  As always, it is important for investors to know and understand all policy terms.  Certainly agents must know this as well.

  If it were not for participation rates and caps, the high water mark indexing method would give investors the highest risk-adjusted returns of any indexing method, but of course there are caps.  It is also important to realize that only the highs reached at the comparison periods count (usually policy anniversary dates).  If a high is reached midway they will not apply.  For example:

· A contract is issued on June 1, 2000.

· On June 1, 2001, the index had increased by 12 percent.

· On December 15, 2001 the increase rose to 42 percent.

· By June 1, 2002 it was down to 10 percent.

  Because only the anniversary dates apply, the 42% index rate will not apply.  Over the next ten years the percent at the anniversary date will be calculated.  At the end of the ten-year term, the investor will receive the highest point recorded on an anniversary date during the term of the contract, up to any applicable participation or rate caps.  It is not unusual to have a participation rate that is less than 100%.

Point-to-Point Indexing Method

  The point-to-point indexing method compares the change in the index at two distinct points in time, such as the beginning of the contract and the end of the term.  Although the investor may enjoy a higher cap and participation rate, which credits more interest, the disadvantage is that it relies on a single point in time to calculate interest.  As a result, even if the index that the annuity is linked to is going up steadily during the contract’s term, if it happens to decline dramatically on the last day of the term, then part or all of the earlier gain can be lost.  Since gain is not credited until the end of the term, the investor may not receive any index-link gain if the policy is surrendered prior to the end of its term.

To recap, the point-to-point index-linked interest, if any, is based on the difference between the index value at the end of the term and index value at the start of the term.  Interest is added at the end of the annuity’s term.

  Even though point-to-point contracts offer the potential for the best long-term returns the disadvantage is the inability to gauge the contract’s performance until the end of the contract’s term, which could be anywhere from five to ten years.  Until that time, the growth will appear to be zero even if the market is significantly up.  If the annuitant dies during the term, for purposes of measuring contract performance, the date of death will be used as the end of the term.

  The point-to-point method may be best for the longest-term EIAs since we can expect the best gains over the longest period of time.  However, since the ending value is based upon that specific point in time, a sudden or unexpected downturn could prove detrimental to the contract’s final value.

  Some point-to-point indexing contracts charge a spread, stated as a percentage, per year.  Others may limit participation to less than 100% or impose caps.  The contract may limit or alter the way the means of crediting based on point-to-point.  They may use the end point to average the index over the term of the contract and credit interest on a compounded basis based on the average rate, less some stated percentage defined in the contract.  As always, all contracts should be fully understood by the selling agent and the investor.

Multiple EIAs with Diversified Indexing Methods

  Diversification is not a new idea; agents and professional planners have been advocating that for years.  Annuities may also be subject to diversification, which is something many investors may not have previously considered.  Obviously, we cannot know in advance which annuity indexing method will perform best over the coming years but investors who purchase several types of annuities are bound to average out their earnings.  This is especially true of equity-indexed annuity types.  Some indexing methods will do better in volatile markets and others will do best in steady markets.

  Many professionals feel the indexing methods of the EIAs are not nearly as important as other issues and features, such as selecting highly rated insurance companies.  While this is true, it is still important to understand the indexing feature chosen.  Also important is choosing a product with competitive interest rates, participation rates, caps and other features.  By purchasing several different EIAs with several different features the investor may minimize lower earnings due to market trends.  Even professional investors realize that it is not possible to guess which indexing feature will perform best in the coming years, since it will depend upon how the markets perform.  Therefore, buying different annuity products with different indexing methods is a good way to diversity within the annuity market.

  Whatever annuity products are selected, they should be purchased from different insurers so that there is diversification of insurance companies.  Of course, all companies should carry no less than an A rating from A. M. Best company.

Withdrawing Annuity Funds

  Most insurance agents are probably familiar with the “income for life” ability of annuity products.  Under this method, the investor can select to receive income for the duration of his or her life; they have an income that they cannot outlive.  However, there is no guarantee as to the actual amount of lifetime income.  Obviously if the investor saves too little in the annuity product, the amount of income stream may be very small (too little to actually support their income needs).  Therefore, the first and most important aspect of saving is to save adequately.  Still saving something is better than saving nothing, so even if the individual knows the amount they are setting aside is inadequate that does not mean he or she should abandon saving altogether.

  Ideally each citizen should begin setting aside money from the time they first receive a paycheck, regardless of how young he or she may be.  Parents are wise to encourage the act of saving a percentage of income from the very first check a child receives for his or her birthday or other occasions from Grandma and Grandpa.  Establishing this financial trait is one of the most important gifts a parent can bestow upon their child since it sets up a habit that will benefit their children for the remainder of the child’s life.

Payout Options

  Annuities are designed for pay-out after age 59½ since the Internal Revenue Service considers them to be retirement designated vehicles.  They may still be used for other goals, but primarily they are considered retirement vehicles.  Although annuities were designed for payout, they are overwhelmingly used for accumulation.  In other words, the majority of annuities are not annuitized (turned into an income stream).  Instead most investors accumulate funds in their annuity, and then simply withdraw the entire value or exchange it tax-free for another annuity, with the accumulation process starting over again.  Often annuities are simply left intact year after year, eventually going to heirs.

  Even though most annuities are not annuitized for systematic payout, it is always important for agents and their clients to understand the available payout options.  When annuities were created the issuers assumed lifetime income would be primarily used.  They were designed to pay a specified amount, based on the total dollars in the annuity, for the remainder of the annuitant’s life, regardless of how long he or she lives.  Under this arrangement, beneficiaries receive nothing even if the annuitant happens to die soon after annuitizing the contract.

For example:

  Annie Annuitant and Alvin Annuitant each have an annuity in their name of equal value (for this example let’s say each Annuitant has $50,000 in their annuity).  Annie and Alvin both choose lifetime income when they annuitize their contract and each receives the same amount each month.  Just to keep it simple, we will say that each Annuitant receives $1,000 per month (the actual figure might be far different, based on the age of each Annuitant and their “life” expectancy).

  Alvin begins receiving his $1,000 per month on January 1.  In June of that same year he becomes very ill, eventually dying three months later in September.  Alvin received a total of nine annuity payments totaling $9,000.  The remainder of his annuity ($41,000 plus accrued interest) will stay with the insurer that issued the policy; Alvin’s heirs will receive nothing.

  Annie also begins receiving $1,000 per month on January 1 just as Alvin did.  However, Annie Annuitant lives to a very old age.  She eventually receives every penny of the $50,000 in her annuity, but she continues to receive the $1,000 monthly payment even though her own funds have been depleted (that’s what “income for life” means).  By the time Annie eventually dies she has received $75,000 from her annuity contract.  As a result, the insurance company paid out $25,000 more than it received.  However, the company also retained $41,000 from Alvin so the insurer still made a profit based on these two people. 

  Insurance companies use analysts to determine expected longevity of their policyholders because their goal is always to earn a profit.  While it is not possible to know for sure how long each person might live, there are indicators that suggest the likelihood of longevity.  Alvin’s beneficiaries are likely to be unhappy about the loss of the remaining $41,000 but Annie’s family will be very happy to see how her annuity paid out.

  Once an annuity contract is annuitized it cannot be changed; the annuitant or policy owner cannot change their mind down the road.  Usually the point of no return is when the first annuity payment is cashed, or if a direct deposit is used, the date the check is deposited.  Each contract may vary so it is important to consult the actual policy for details.  Since the payout option is locked in agents must be certain their clients understand the advantages and disadvantages of each payout option.

  It is very important to realize that all annuities may not necessarily offer all payout options.  If a particular payout option is important to the buyer, he or she will want to specifically examine the available payout options listed in the policy.  Any questions should be addressed prior to purchasing the annuity.

Nonhuman Payees Under a Settlement Option

  Many contracts require the payee under a settlement option to be a human being, meaning they will not make payments to an entity such as a business.  All settlement option payments during the life of the contract owner are typically made by check to the primary payee or by electronic transfer directly into their bank account.

Lifetime Income Payout Option

  Different contracts may call lifetime income by different names, such as “Life only”, “Annuitant Lifetime”, “Straight Life” or other similar names.  In each case, a definition will be in the policy.  As discussed, annuities were designed to provide a systematic income at some point in time.  When a policy owner annuitizes his or her contract, surrender penalties will not apply even if the contract is still in the early years of the surrender period.  Annuitization is the process of beginning systematic payments to the annuitant.  Some EIAs allow the investor to vary the frequency and amount of the payout to meet the investor’s particular needs.  Other than surrender charges, which are waived if the contract is annuitized, the only real limitation regarding payments applies to taxes.  It is necessary to wait until the attained age of 59½ to avoid a 10% early distribution federal tax.

  One of the most important benefits of deferred annuities is the ability to use the built-up values during the accumulation period to provide income during the payout period.  Income payments are typically made monthly, but it is possible to choose some other systematic time period, such as quarterly or even annually.  Annually may allow the investor the ability to pay debts that occur only once per year, such as property taxes or some types of insurance (long-term care insurance for nursing home coverage for example).

  It is very important that annuitants and annuity contract owners realize that the lifetime income option does not consider beneficiaries.  However, since the insurer does not have to consider beneficiaries the payout option is often higher.  In other words, the systematic payment to the annuitant will be higher because, as in Alvin’s case, the insurer will keep any unused funds.

Life Annuity, Period Certain Payout Option

  The Life-Annuity-Period-Certain option will pay the annuitant less in each systematic payment than would have been received under the Lifetime Option.  That is because there is a specified time period involved (Period Certain).  Under this payout option the annuitant is guaranteed to receive a specified amount, as determined at the time of annuitization, for his or her lifetime regardless of how long he or she lives.  The annuitant is also guaranteed that if he or she dies prior to the stated time period his or her heirs will receive the remainder of the funds.

  In Alvin’s case, if he had chosen this option, he would have received less each month; he might have received $750 each month rather than $1,000 for example.  If he chose a ten-year period certain his beneficiaries would have received the remaining $41,000 because he did not reach the selected ten year time period.  The time period does not have to be ten years of course; the period of time depends upon what is selected at the time of annuitization.  Many insurers offer a variety of time periods, perhaps 5-, 10-, and 15-year periods.  The amount of money received on a systematic basis will reflect the “period certain” selected.  The longer the “period certain” the less the annuitant will receive as income each month.  That makes sense since the insurer increases its risk when longer periods are selected that guarantee beneficiaries will receive remaining funds.  Once the guaranteed period (period certain) expires beneficiaries no longer receive any remaining funds.

  If the annuitant dies during the period certain, his or her beneficiaries will receive the remaining funds based on contract language.  In other words, the contract may state that a lump sum will be paid to the beneficiaries or it may state that the beneficiaries will continue to receive funds as the annuitant would have based on his or her income selection.  In Alvin’s case he was receiving monthly income (the most common selection) so his beneficiaries would continue to receive monthly installments if that was the beneficiary terms of the contract.  Many contracts allow the beneficiaries to make their own choice between two or three options, including a lump sum distribution.

Joint-and-Last-Survivor Payout Option

  When there are two people in the household, such as husband and wife, the joint-and-last-survivor payout option is often selected since it pays an income to two named individuals.  Of course, they are not required to be husband and wife, but that is commonly who uses this payout option.  Since two people are guaranteed a lifetime income it is not surprising that the monthly installments are less for two people than they would be for a single individual.  In some annuity contracts utilizing this payout option, the amount of systematic income is reduced upon the death of the first named individual; others continue paying the same amount.  Some contracts offering this payout option will give a refund to heirs if both named individuals die within a stated time period.  If this is the case, the payout option might be called Joint-and-Last-Survivor-Period-Certain.  As with other payout options, there might be variances in the name the contract uses, but they will be similar enough to the name we have used that there should not be any confusion.  As always, the contract definitions will also state how the payout option works so agents and insureds should refer to their policy.

Required Distribution

  Most annuities have some point in time when the contract must be annuitized or closed.  The contract may be closed simply by withdrawing all funds.  Mandatory distributions will be after the surrender period has expired, so such penalties will not apply.  If the annuitant has not reached age 59½ the IRS early distribution penalty would apply on any funds that were withdrawn.

  Annuitants and contract owners could choose to simply roll the annuity into a new contract, which would meet mandatory distribution requirements of the contract but avoid any IRS penalties.  If the annuity was rolled into a new annuity contract new surrender periods would begin, since most annuities have them.

  Unfortunately, some equity indexed annuities have mandatory annuitization, whether the investor wants to or not.  Generally financial advisors recommend against buying these products.

Taxation

  Annuitization works the same whether the annuitant or contract owner will owe taxes on the earnings or not.  What will be different between a non-qualified annuity and a tax qualified annuity is the taxation.  If the annuity is not a qualified annuity taxes will be due as the growth is paid out.  Under current tax status, the first money withdrawn is considered to be growth, with the last money withdrawn being principal.  In a non-qualified annuity, the principal was taxed prior to deposit.

  Annuity gains are taxed at ordinary income tax rates, which can be high.  In fact it can be substantially higher than taxes on long-term mutual fund gains if withdrawals are not made during low income years.  The difference can eat up the advantage of an annuity's tax-free compounding.  It may take 15 to 20 years before tax-deferred annuities become more tax efficient than a mutual fund, even though the mutual fund is not tax-deferred.  However, many people do keep their annuities for 15 to 20 years or even longer.  Additionally, many people are not looking at how the gains will be taxed because funds will be gradually withdrawn as lifetime income or because they will be in a lower tax bracket in retirement.

Qualified and Non-Qualified Annuitization

  Annuities are used in all types of tax-favored retirement plans maintained by employers for the benefit of their employees.  This is especially true of qualified plans such as 401(k) plans, tax-qualified defined benefit plans, 412(i) plans and employee stock ownership plans, governmental 457(b) plans and Section 403(b) arrangements.  Individual retirement arrangements (IRAs) are also considered workplace retirement plans, such as SEPs and SIMPLEs.

  The Internal Revenue Code allows preferential tax treatment for workplace retirement plans.  Of course, there are requirements that must be met.

  There are differences between the plans, but all tax-favored plans have limitations on the contributions or benefits that may be made on behalf of any plan participant.  Primarily the use of benefits must be restricted to retirement purposes.  In addition, some tax-favored plans require minimum coverage and nondiscrimination rules that are intended to ensure the plan covers a cross-section of employees (it cannot be discriminatory) and provides meaningful benefits to covered employees.  The types of plans used by employers usually are attributable to their type of business.

  Section 403(b) arrangements (tax-sheltered annuities) may only be maintained by employers that are exempt from income taxes, and state and local government schools.  Governmental 457(b) plans may only be maintained by state and local governments and they differ from tax-exempt 457(b) plans.  Tax exempt plans are a type of nonqualified deferred compensation plans maintained by non-governmental tax-exempt entities, most notably charities and private universities.  Government 457(b) plans are a type of tax-favored retirement plan.

  Tax-qualified plans can be sponsored by all employers as a general rule but state and local governments cannot maintain 401(k) plans.  A 401(k) plan is a qualified plan that permits employees to make pre-tax salary reduction contributions (the employee can elect to have salary reduced in exchange for an employer contribution which must be equal to the reduction in salary).  Section 403(b) plan arrangements and governmental 457(b) plans are similar to 401(k) plans since they permit employees to make salary reduction contributions and all three plans receive the same preferential tax treatment.

  Normally, contributions to a tax-qualified plan, Section 403(b) or governmental 457(b) plans are excluded from an employee’s gross income and most state income tax laws if the contributions satisfy certain conditions and limits, and the earnings that are credited to the employee under the plan, accumulate on a pre-tax basis.  Contributions and earnings become taxable only when they are distributed, but once they are distributed, these amounts are taxable as ordinary income (unless they are rolled over to an IRS, qualified plan, a Section 403(b) program or governmental 457(b) plan).

  As of January 1, 2006, a qualified plan or a Section 403(b) plan (not a governmental 457(b) plan) may allow employees who make salary reduction contributions to designate some or all the contributions as Roth IRA contributions.  This means that the earnings credited to the employee and attributed to the Roth contributions accumulate tax-free.  A distribution of an amount attributable to the specified Roth contributions, which includes earnings, is entirely excluded from the employee’s gross income under the IRS Code and most state laws.  Distributions that are attributable to Roth contributions are tax-free in most cases.  If, for instance, the taxpayer is in the same tax bracket at all times and tax rates do not change, then there is no real difference between the tax treatment of a pre-tax contribution and a Roth contribution, with the exception that a Roth contribution produces a larger ultimate benefit than would a pre-tax contribution of the same amount.

ERISA and Tax Favored Retirement Plans

  Primarily, the laws applicable to tax-favored retirement plans are part of the Employee Retirement Income Security Act of 1974 (ERISA) and the Tax Code.  State laws do not usually apply to ERISA-covered employee benefit plans since ERISA usually preempts all state laws that relate to ERISA plans; however, ERISA does not preempt state insurance, banking or securities laws, even if they do relate to an ERISA plan.  As a result state laws will apply to an annuity used in connection with an ERISA-covered retirement plan.  ERISA-covered plans must comply with federal securities and bankruptcy prohibitions on employment discrimination and other such laws and restrictions.  Governmental plans like 457(b) plans and Section 403(b) arrangements are not affected by ERISA, so governmental plans are regulated by state statutes and regulations.

Using Annuities in Tax Favored Retirement Plans

  There are three primary ways that annuities can be used for tax-favored retirement plans:

1. Funding a tax qualified plan, government 457(b) or Section 403(b) plan.
2. Funding held as assets in trusteed retirement plans, and
3. Annuities used to settle benefit obligations.

  Annuities can be used to fund a tax-qualified plan, a governmental 457(b) plan or Section 403(b) arrangement.  Usually the assets of tax-favored retirement plans must be held in trust by one or more trustees or in a custodial account with one or more custodians.  However, an annuity issued by an insurer that is qualified to do business in the state may be used instead of a trust or custodial account.  These plans are often called “non-trusteed plans.”

  Annuities may be held as an investment asset in a trusteed retirement plan.  For example, the plan could purchase and then hold in trust a group annuity contract that would provide a method for offering and making life contingent annuity payments to participants.  As a result the trustee would be the owner of the annuity contract.

  An annuity may be provided to the participant of a retirement plan with the participant as the named owner.  The insurer would then assume the obligations of the plan.

  Surprisingly the tax code does not specifically define “annuity” although it does impose several requirements on annuity contracts.  Generally, the tax law requirements for annuity contracts do not apply when annuities are used with a tax-favored retirement plan, in which case there are some specific requirements:

• The annuity contracts that are used in qualified tax-retirement plans are exempt from the diversification requirements that apply to variable annuities.
• Annuities used in tax-favored retirement plans are exempt from the IRS Code that states the annual increase in an annuity held by a non-natural person is taxable to the owners, unless the contract is held as an agent for an actual person.  The effect of this is that the non-natural person owning the annuity is taxed on earnings from annuities under qualified plans unless there is an exception.

IRS Requirements for Annuity Funding

  Annuity funding for tax-qualified plans must be nontransferable.  The owner is not allowed to sell, assign, discount or pledge as collateral for a loan, as security for the performance of an obligation or for any other purpose, his interest in the contract to any person other than the issuer.  Additionally, the annuity contract must specifically contain provisions making the contract nontransferable.

  Other than the non-transferability of the contract, there are no other special requirements required for an annuity that funds a tax-qualified plan.  There are numerous regulations and requirements for the plan itself but since the annuity funding the plan usually does not have the qualifications for the applicable plan, the same thing is accomplished by separate plan documentation kept by the employer.

Taxation of Qualified Annuity Distributions

  When distributions are made from tax-qualified retirement plans it must first be determined if the plan was transferable.  If it was transferable, then the fair market value of the contract is taxable to the person receiving the distribution.

  If the annuity plan is nontransferable, and assuming the plan meets the qualification requirements applicable, the contract is tax deferred and tax is assessed only upon actual payments from the contract.  The right of an individual to surrender a nontransferable contract for value does not affect the taxation.  The cash surrender value is considered as income only when the contract is actually surrendered.

  The principal requirement of a distributed annuity is determination of taxability at the time of distribution.  If it is found to be taxable there are no particular requirements that apply to the contract, but if the distribution is not taxable because it is nontransferable, then the annuity is required to adhere to several tax-qualification requirements.

  The IRS or the Treasury Department has provided no specific requirements for an annuity distributed from a tax-qualified plan to adhere to and there are several unanswered questions regarding the status of a distributed annuity contract.  For example, it is unclear if loans are permitted from a distributed annuity contract or whether a distributed annuity can accept rollover contributions under IRS law.  The answers seem to depend on whether a distributed annuity is considered as a continuation of the qualified plan.  If it is, then probably the contract would have to satisfy all of the requirements of qualification and would then be entitled to the benefits of qualified plan status.

  It has been suggested that the distributed annuity contracts must satisfy some (limited) qualification requirements but are not subject to all of the qualification requirements.

  Most tax-qualified plans require the distributed annuity contract show the direct rollover requirements of Section 401(a)(31) and the spousal consent requirements of Section 401(a)(11) that requires the insurer to be responsible for obtaining spousal consent to certain distributions.  Also the distributed annuity must satisfy certain anti-cutback rules which specifies that benefits, which include some optional forms of payout, must be preserved in the distributed annuity to the same extent that they need to be preserved in a plan and minimum distribution rules of Section 401(a)(9).

Financially Sound Insurers

  One of the first investment considerations must be the entity selected to deposit funds with.  Whether the investor is buying an annuity, a Certificate of Deposit, or simply opening a Christmas club account, the sponsoring organization’s financial strength (or lack thereof) should be considered.

  When selecting an annuity product, the sponsoring organization is always an insurance company.  Whether the product is bought at the investor’s local bank, from an insurance agent, or over the internet annuities are always issued by an insurance company.

  Once the annuity product is past the surrender period generally the only way to lose money is if the sponsoring insurance company becomes insolvent.  Obviously no investor wants to be with an insolvent company.  Guaranteed return is only as good as the entity sponsoring the investment; in the case of annuities that would be an insurer.  Luckily most annuity insurance companies do not become insolvent, but it can happen.  Historically annuity companies seldom fail.  Other investments are far more likely to experience insolvency than annuities.  It is so rare for an annuity insurer to become insolvent that even critics of annuities seldom mention the possibility.  Even so, it is important to utilize only financially secure insurers because even a very small chance of failure is important.

  There are distinct differences between variable annuities and fixed annuities.  Fixed annuities are not backed by segregated reserves or specific assets, as variable annuities are.  For the equity indexed fixed annuity investor he or she does not own the index, index shares, or stocks comprising the index.  Equity indexed annuities are contracts.  EIA investors own those contracts, which promise to pay money in the future from its general assets.  Sound familiar?  That is basically what life insurance policies are: contracts that promise to pay funds in the future if the insured dies during the term of the policy.  Although equity indexed annuities are not life insurance contracts both contract types promise future payments.  Annuities are backed by the assets of the annuity company (not just specific assets or specified pools of assets), which explains why it is very important that only financially secure companies be selected.  EIAs are roughly comparable in their safety to money-market funds according to Jay D. Adkisson, JD, author of Equity-Indexed Annuities: the Smart Consumer’s Guide.[1]

  Insurance companies must keep state-required reserves and other assets to satisfy their financial obligations, although the requirements may vary state by state.  However, agents should never use their state reserve requirements as a marketing tool; rather agents should select financially secure annuity insurance companies to represent.  The general public is not likely to understand how state-mandated reserves work and usually rely on their agents to select companies they can feel secure with.  Although the states have an insurer guarantee fund (which each licensed company pays into) that never takes the place of due diligence.  The wise agent will only consider financially top rated companies to represent.

  How does the agent know which companies are financially strong?  Although agents could perform their own due diligence most simply rely on the rating companies to do so.  Companies whose primary function is to measure the financial strength of insurance companies generally do a good job of determining which company is weak and which is strong.  They assign ratings to the insurers that tell agents the company’s financial strength.  Several companies perform these ratings so it is possible to look at more than one company’s opinion of an insurer’s financial strength.

  Each rating company will have their own rating method so agents and investors must take time to understand how the ratings apply.  Some professional financial planners have favorite rating companies, but generally it is recommended that agents consult more than one company.  Each rating company will give their interpretation of the insurer’s strength and weakness.

State Guaranty Associations

  Although insurance companies are traditionally stable, companies can experience financial difficulties.  State life and health insurance guaranty associations provide a safety net for their state’s policyholders.  The goal is to provide a promise that policyholders will continue to be protected even if their issuing insurer is no longer solvent.  It is always best to use highly rated companies and insurance producers may never use state guaranty associations as a sales tool or as an inducement to purchase insurance from an insurance company that is not highly rated or financially stable.  Only very foolish agents would recommend any company that is not currently stable.

  Insurance companies are monitored by the various state regulators; the goal is to recognize a company in financial trouble and protect their state’s policyholders from a failing company.  If the state finds a company is in financial distress, within the laws of the state, every attempt will be made to correct the situation.  This time period is usually referred to as “rehabilitation.”  If the company cannot be rehabilitated it will be declared insolvent.  At that point the laws of the particular state will allow the commissioner to ask the state court to order liquidation of the insurer.

Suitability Standards

  Many states have mandated suitability standards for annuities because there have been errors made in the past.  Most agents intend to do a good job for their clients but unfortunately some agents did not understand whether the annuity was suitable for their client’s financial situation or not.  By mandating suitability standards (and in some cases special suitability education) the state insurance departments hope to avoid errors that may cause financial harm to its citizens.  Suitability standards provide guidelines for agents who may not otherwise understand how to determine product suitability.

  In the absence of state mandated criteria insurance product suitability may be a matter of opinion.  For example, advocates of equity indexed annuities may feel that there are no bad EIAs while critics may feel there are no good EIAs.  While there are no so-called good or bad products, there are certainly situations that are suitable and unsuitable, based on the particular person’s circumstances.  The goal of the agent is to determine if his or her particular client’s situation would benefit from an annuity.  If it would not, then any type of annuity product may not be suitable.  It is also possible that one type of annuity may meet the client’s goal while another type of annuity would not.

Determining Suitability

  There are several elements that determine whether a product is suitable, including the individual’s risk tolerance, financial needs, cash reserves, and personal or financial goals.  In some cases, it is obvious that an annuity is not suitable or perhaps that some types of annuities are not suitable.  As we know (or should know by now), there is no product that is always right for every investor.  It is misleading to compare one annuity product to another if the features each offer is vastly different.  We often hear this stated as “comparing apples to oranges.”  Each is a fruit, but the differences are great enough that they cannot be adequately compared.  The same is true for some types of annuities.

  Agents must stress that it is not possible to predict how the markets will perform in the future.  Even looking at past performance seldom offers guidelines, as we have witnessed over the last few years.  Unfortunately, clients often blame their agents when investments perform poorly, so it is in the agent’s best interests to have a written statement regarding the inability to make predictions.  This statement should be signed at the time an annuity is purchased and kept by the agent in the client’s file.  Consider this signed statement future protection if the client or his or her family becomes dissatisfied with the investment’s performance.

  Agents must ask their clients to consider several questions when considering the appropriateness or suitability of an annuity product, especially if that product is an indexed or variable contract.  The following questions are not inclusive, but they are likely to be among the necessary questions to ask:

1. What is the soonest date the investment money will be needed?  In other words, when will the money need to be withdrawn for daily living requirements?
2. Will annuitization be an option or does the investor think he or she will want to withdraw the investment as a lump sum?
3. Depending upon the date of withdrawal, could the surrender penalties be imposed if funds were withdrawn and the policy surrendered (not annuitized)?
4. Does it seem likely that withdrawals will be needed that are larger than any “free withdrawals” allowed under the annuity contract?  This relates to any insurer imposed surrender penalties.
5. How old does the investor expect to be when funds are withdrawn?  This relates to the IRS penalty if funds are withdrawn prior to age 59 ½.
6. What is the intended use of the annuity investment?
7. Is the investor more interested in the highest possible gains or in preservation of principal?  This relates to risk tolerance.
8. It is not possible to have both the highest rate of return and little or no investment risk.  Does the annuity client understand this?

  When agents ask these and similar questions of their clients their focus should be on the most adverse possibilities.  For example, if the investor thinks he or she may need large withdrawals during the surrender phase of the contract it is likely that an annuity of any type may not be suitable for their personal circumstances.  Even if it is only a possibility that money may be needed it would be foolish to tie up all available funds in a non-liquid investment.

  Investors and agents should never simply assume liquidity will be available somewhere outside of the annuity, such as home equity or amazing investment growth.  Taking the optimistic view does not comply with product suitability requirements.  Any investor that does not have sufficient liquidity for the surprises in life should not invest everything in an annuity; enough cash reserves should be retained in a liquid account of some kind.  This is true for all investors of all ages.  We all need an emergency account that can be easily accessed.

  Annuities are often used to pass wealth on to heirs, such as children and grandchildren, but many financial managers feel that goal is better served with a life insurance policy.  This might be true even if the money in the annuity will not be needed at any future date.  The life insurance policy should be held outside of the estate to minimize delays in distributing funds.  These issues should be discussed with a qualified financial planner or attorney of course, so that the best avenues are utilized.

  Equity indexed annuities are complex; if the selling agent feels the concepts are not well understood by the investor it could prove foolish to still initiate an application for the product.  Perhaps a traditional fixed annuity would be better understood than an equity indexed annuity.  If so, that might be a better product to place with the investor.  Agents should never place a product that is not adequately understood and accepted by the investor.

  Annuities are considered long-term investments.  Never should excessive funds be tied up in long-term vehicles.  Even when the investor does not expect to need the funds it is impossible to predict future circumstances.  The investor could lose their job, experience an uncovered medical emergency or simply need a new refrigerator.  All adults need an emergency cash fund that is easily accessible on short notice.

Sales Practices

  Agents know they are required by every state to be honest in the course of practicing their profession, but appropriate sales practices go beyond that.  Agents could adopt the medical profession’s code of “do no harm.”  The first step in any financial transaction is acknowledging that wrong choices could financially affect the buyer.  Unfortunately, the buyer is often unaware that he or she has been adversely affected until years later when they reach retirement or some other pre-planned goal.

Product Replacement

  There are situations that call for replacing one existing product with a newer insurance product, but this is not true in every case.  Agents should never replace an existing product with another unless there are specific reasons for doing so – and those reasons are sensible.  Especially when an annuity is the investment tool involved, there are times when replacement might be unwise.  This would especially be true if the annuity owner’s contract was past the surrender period.  Putting the buyer into a new annuity with a new surrender period should not be done without serious thought.

  Obviously, agents must observe all state-mandated replacement procedures.  Most states have specific replacement procedures, which must be followed.

Deceptive Sales Practices Forbidden

  Some agent practices are considered deceptive.  These would include high-pressure sales, quick change tactics, or anything that is less than an honest presentation of the product facts.  Just as agents must correctly and honestly present their own products, they must also correctly and honestly present other products, such as the policy the agent is attempting to replace.

Full Disclosure

  As we know some products are more complex than others.  A criticism of equity indexed annuities, for example, is their complexity; even many agents avoid presenting them purely due to lack of product understanding.  Only when the agent understands the product will he or she be able to adequately communicate all aspects of the investment to their clients.

  It is very important to fully disclose all product characteristics, including product limitations.  Buyers will make better decisions when they understand the various products and are able to make an informed decision.  More importantly for the agent’s commission is the fact that buyers will keep the product when they are satisfied that an informed decision was made.

Product Knowledge

  Agents must know the products they represent and be able to adequately communicate the product’s characteristics to potential buyers.  For example, even advocates of equity indexed annuities admit that they are more complex than most other types of annuities.  Since EIAs are not all the same, an understanding of one EIA product does not guarantee understanding of all EIA products.  Although the basic concept may be understandable, that does not automatically mean the agent or investor understands the individual products being marketed.  Even experienced financial planners often have to read the actual equity indexed annuity policy to gain an understanding of how the individual product performs.  Certainly, agents must read and fully understand any product they plan to present to consumers.

Identifying Suitability Issues

  Suitability issues seem to arise for some basic reasons, including (though not limited to):

1. The agent believes he or she understands the annuity product but does not know how to convey the terms and limitations to their clients, so they adopt a “trust me” mythology when selling them.
2. The agent realizes he or she does not understand the “details” of the product but believes the details are not important enough to worry about and markets the product anyway.
3. The agent mistakenly believes he or she understands the product they are selling.  Even though it may result in an unintentional agent error, the end result can cause great financial harm to the investors.  Financial harm often results in lawsuits.
4. When investors clearly misunderstand how a product works, only a fool will sell the product anyway.  When agents know their clients have misunderstood the proposed investment under no circumstances should the product be placed until the investor’s error is corrected.

  Just because an investment product, such as equity indexed annuities, are complex does not necessarily mean they should not be sold.  If agents understand the mechanics well enough to relay a full understanding to their clients that will likely be sufficient.  The point is to understand the ups and downs well enough so clients do not get nasty surprises later on.  Many agents will gain a full understanding of just one or two equity indexed annuities and sell only those particular EIA products.  This prevents any harm done to their clients as long as suitability standards are observed.

  The states have a very difficult job.  They must attempt to eliminate use of the “trust me” technique used by agents to place annuity products regardless of client suitability.  It is doubtful that the states will ever be able to completely eliminate unethical agents but with required suitability standards the states at least have an avenue to punish those who refuse to act ethically.

  Every product has advantages in the right circumstances and disadvantages in the wrong situations.  The goal is to place products where they are most likely to be advantageous for the investors.

  There is no question that annuities are long-term investments and, as such, lack liquidity.  Large early withdrawals – prior to the end of the surrender penalties – could result in loss of principal due to penalties.  Therefore, large withdrawals are not suggested during the surrender penalty years.  Many products allow smaller withdrawals during the surrender penalty years without any insurer fees so this may be an avenue for those who sometimes need to withdraw cash.  All annuity investors must be aware of the Internal Revenue Service penalty of 10% on withdrawals prior to age 59½, called early withdrawal penalties.

  It is due to these early withdrawal fees, both from the IRS and the insurer, that make it theoretically possible for equity indexed annuities to lose money; this is not true of traditional fixed rate annuities where the principal is guaranteed.  According to NASD, the guaranteed minimum return for an EIA is typically 90% of the premium paid at a 3% annual interest rate.  If, however, the investor surrendered his or her EIA early, he or she could end up paying a significant surrender charge and a 10% tax penalty that would reduce or even eliminate any returns and might even reduce principal.

  Since many EIA products only guarantee a return of 90% it is possible to lose money on equity indexed annuities, whereas traditional fixed rate annuities guarantee 100 percent of the amount deposited into the annuity product.  Obviously one way to avoid this is to look for equity indexed annuities that guarantee 100% of the premiums paid.

  Some equity indexed annuities do not pay earnings until maturity, which is usually the point at which the surrender penalties end.  In other words, some contracts will not credit the annuity with the index-linked interest if it is surrendered early.

Long-Term – Not Short-Term Use

  Annuities of all kinds are typically long-term investments so the issue is never about liquidity (there is none) but rather about suitability.  When the topic seems to snag on liquidity it is usually a sure sign that the agent should not place an annuity with the investor.  In most cases annuities are only suitable for those who will not need to withdraw significant sums during the contract term.  Even small withdrawals should not be an issue when addressing product suitability.  Withdrawals prior to the annuity term should never be a goal – period.

  Although some annuities may have provisions for withdrawals under specified conditions, such as medical need, if the investor has set aside sufficient liquid reserves (outside of any annuities purchased) even that should not be a topic.  Agents and financial planners should assess liquid reserves prior to determining annuity suitability – prior to suggesting buyers consider an annuity of any kind.

  Some investors tend to be spenders and will spend funds if they are available, even if set aside for other purposes.  Such people have difficulty maintaining emergency cash funds because they are constantly removing the funds for other purposes.  For such individuals an annuity might seem attractive because they are long-term, illiquid financial vehicles.  The lack of liquidity may seem beneficial as a result.  When consumers look for financial vehicles that prevent them from removing funds this is known as lock-boxing, but many are skeptical of using annuities in this way.  If the investor cannot maintain an emergency fund he or she may access their annuity anyway so the illiquidity is not ultimately a successful deterrent.  In fact it may make the situation worse as insurer penalties for early withdrawal are levied.

  There are circumstances where lack of liquidity is an advantage.  This might be true for an individual that needs money kept out of reach, and will not access the annuity on a whim.  For example, an inheritance that is not needed for daily living costs or emergencies might do well in an annuity.  This might especially be true for investors who are behind on saving for their retirement.

Generally speaking, creditors cannot access funds in an annuity so, for some people who are having credit issues, the inaccessibility of annuities might prove to be an advantage.  Creditors can usually access such things as bonds, stocks or mutual fund shares, which would have to be sold at current market value even if that means a loss.  Not all states offer creditor protection for annuities so investors should seek legal council.  It might even be prudent to establish residency in a state that does offer protection for funds placed in annuities.  In such states creditors would never be able to get access to annuity funds (sometimes even annuity payments may receive protection from creditors).  Seldom would an annuity be protected from Internal Revenue Service claims however.

A Comprehensive Financial Plan

  It is unlikely that any one type of financial vehicle would be sufficient to comprise a fully adequate financial plan.  Annuities must be part of a portfolio that considers all types of investment vehicles so that the investor’s goals and aspirations are fully satisfied.  Assets must be logically divided among several types of financial vehicles so that the investor’s full needs are met.  An agent or financial planner that merely divides the client’s assets among an array of annuities, even if diversified among several indexes and annuity types, is probably not doing an adequate job of protecting his or her clients.  Generally, it takes several types of investments to appropriately address possible future returns and investment risks.

  Most annuities (with the exception of variable annuities) are considered safe financial investment vehicles.  Equity indexed annuities could be classified with cash and equivalents such as Certificates of Deposit and money market accounts because they are made up of fixed annuities, which are traditionally safe.  The risk is small that the investor will not receive at least the minimum returns.  While we would all like to see huge growth, safety of principal is typically the primary concern.  The biggest risk is not loss of premium (principal) but rather that the growth will be too small to match or exceed the rate of inflation.  It is possible that loss of buying power could occur with annuities.  In other words, while the principal is maintained the interest earned is too small to maintain the same level of buying power ($100 may only buy 80% or $80 of what it once could buy).  This is the same risk that all conservative financial vehicles face.  Lower financial risk also means lower rates of interest earnings, so lower rates of growth.

  Fixed annuities guarantee that a certain amount will be available at some point in time (depending on contract terms) but they do not promise that the returns will keep up with rates of inflation.  Even though annuities are not liquid financial vehicles, they do promise that at least the principal will be available at some specified date.

  Many investors like to “ladder” their investments, with some coming to maturity each year during retirement or at least during the early years of retirement.  Many investors stagger their investments to reach maturity in five-year increments.  The goal is to provide continual income during retirement; as one investment is used to fund retirement costs, the next investment matures and takes up where the last investment ended.  Laddering is often used to keep current interest rates, since once an annuity is annuitized payments are set and not subject to changing interest rate environments.

For example:

  Rachel Retiree has given lots of attention to her retirement planning.  She has Social Security income, which is too small to live on, but no pension from her working years.  Knowing that she would not receive a pension she saved regularly throughout her working years.  With the help of a financial planner she knows approximately what her living costs will be in retirement.  The only unknown factor was the rate of inflation so she tried to have more than she thought would be necessary available from her investments.  If inflation is greater than anticipated she hopes the “extra” will cover the rising costs of living.  On the other hand, if inflation is not as great as she thought it would be she will have extra funds, which of course is what Rachel is hoping for.

  In year one of her retirement a Certificate of Deposit matures and is used to fund the first five years of Rachel’s retirement. 

  In the fifth year of Rachel’s retirement, a fixed rate traditional annuity is annuitized to provide monthly income for the next five years.  Because it will pay out all funds over just a five year period Rachel will actually be able to put part of the income into a liquid savings account to cover unforeseen emergencies, such as health care needs or dental costs.  This expectation of extra funds may not materialize if inflation soars but if it does not she will be over-funded.  Although she could use the extra money for travel or other pursuits Rachel is wise enough to realize the future may cost more than the present.

  In the tenth year, when Rachel is 72 years old (she retired at age 62 when she could begin collecting Social Security benefits) an equity indexed annuity matures.  This annuity promised better returns than her traditional fixed rate annuity so she chose to have it mature when she was older.  She felt it may give her more income at a time when living costs would possibly be higher due to inflation.  By this time she also hopes her modest stock investments will have grown sufficiently to produce any additional funds that she might need for such things as higher insurance premiums on her health insurance or medical needs associated with growing older.  Rachel knows she took on an extra risk when she chose not to buy long-term nursing home insurance.  She felt she would not be able to pay the potentially rising premium rates of such insurance.  Rachel hopes she will not need nursing home care even though historically she is likely to, if just from the frailty that comes with aging (especially for women who make up the majority of nursing home residents).

  In the 15^th year of Rachel’s retirement, when she is 77 years old, her final investment will be utilized, a bond fund.  Obviously Rachel does not know how long she will live but Americans continue to live longer than those before them.  It is certainly possible that Rachel could live to be 100 years old.  She can only hope her money will last as long as she does.  Rachel could have chosen lifetime income from her annuities to guarantee funds for as long as she lives.  She chose to receive income for shorter periods of time because she felt lifetime payments would be too small to cover her expenses.  Rachel can only hope she made the best choices for herself.

  While equity indexed annuities might be classified with cash and cash-equivalents because of their high level of safety they tend to offer some advantages:

• Some EIAs offer a minimum interest rate that could be compared to that offered by CDs and money market funds.
• The interest earned on equity indexed annuities is tax-deferred.  This offers a substantial gain over a period of growth years.  If withdrawals are taken when the investor is in a lower tax bracket this could be a substantial advantage over other types of investments.
• EIAs offer the ability for equity-like participation in the stock market according to the index linking feature.  Obviously money market accounts and certificates of deposit cannot do this.  Most financial advisors feel this could offer a greater chance of beating inflation.

  It is easy to see why professionals who are familiar with equity indexed annuities might choose them over Certificates of Deposit and money market funds.  Still most people tend to keep more money in certificates and money markets than they do in annuities, since funds in the local bank are more accessible than funds held in an annuity.

  Agents may sometimes see equity indexed annuities compared to some types of bonds.  Investment returns may be similar, although most bonds do not enjoy the tax deferral that annuities enjoy.  Even so, if withdrawals may be needed before an annuity would mature bonds might be a better choice for the investor.  However, if liquidity is not a concern, it is typically better to invest in the annuity because:

• The annuity will be tax deferred; some types of bonds may also enjoy this feature (municipal bonds for example) but they usually have very low returns.
• Bond values can go down if interest rates go up.  This would mean holding the bonds to maturity to get the full values from them.
• Bonds are subject to market risks, such as inflation and speculation.
• Equity indexed annuities may do better than minimum rates if the index they are linked to perform well.  That would mean better performance than bonds are capable of.

  This does not mean that bonds have no place in the investor’s financial portfolio since they do offer liquidity that is not available in annuity products.  Bonds are used for liquidity while annuities are used for long-term performance.  Bonds might also be the investment choice if funds will be needed prior to age 59½ since annuities would be subject to IRS early distribution penalties for withdrawal prior to that age.  As we previously noted, it is always an issue of product suitability.

  There is another difference between bonds and some types of annuities: investors cannot wait for annuities to decline in price and then buy them.  Since bonds can go up and down in price, investors might wait for bond prices to go down before they buy them.  Equity indexed annuities can only go up in value and have only positive correlations to the asset classes that overlap the index the product is linked to.

  Agents and financial planners may sometimes want to compare equity indexed annuities to mutual funds or index shares.  Mutual funds are vehicles made up of various stocks.  Index shares are stocks that track the index.  EIA critics often do not like that the annuities limit participation in returns if the index rises.  It is true that the investor would do better with mutual funds and index shares if the index goes up, but what if it goes down?  Investors that want to enjoy guarantees typically realize there is give-and-take when it comes to lowered market risk.

  EIAs are subject to participation rates, caps and other limitations.  Utilizing equity indexed annuities should not mean anticipating higher gains than those stated; instead the investor should only consider the minimum guarantees.  Higher gains are merely a plus to the diversified portfolio.

  Mutual funds typically have fees and expenses that affect the final performance.  That does not mean they should not be part of a diversified portfolio but product costs should be considered.  Mutual funds carry risks besides fees; managers are not always the best or a good manager may not remain.  Managers may take excessive risks, putting the funds in a position to take a loss.  Mutual funds are not necessarily tax efficient.  Most equity indexed annuities do not have fees or expenses and do not experience annual taxation.

  For some investors who track the index mutual funds may be their investment of choice but generally a well rounded portfolio is best.  That means having some of many different investments, including annuities.

Tax-Deferred Status

  As every agent knows, annuities enjoy tax deferred status on interest earnings.  Taxes are eventually paid, but not during the accumulation phase.  When funds are withdrawn, taxes will be due in the year the funds are withdrawn.  Basically, taxation will occur when gains are withdrawn, payments begin (annuitization), or the annuitant dies, with the annuity then being distributed to heirs.

  Annuities are tax deferred so during the accumulation phase no taxes are due on the interest earnings.  When partial withdrawals are taken, interest is considered to be withdrawn first and principal (premiums) withdrawn last.  Therefore, taxable gains are the first to be withdrawn and gains would be taxable upon withdrawal.  This is called the “last-in-first-out” withdrawal method, often stated as LIFO.

  When taxation is delayed, such as happens during the accumulation phase, it allows the financial vehicle to gain more growth because interest is earning additional interest (compound interest in other words).  Tax deferral also allows the annuity owner to choose when taxes are paid by waiting until the right moment to make withdrawals.  It would make sense to time those withdrawals with a year having lower income.  In most cases it also makes sense to obtain tax advice from a tax specialist.  He or she can help the annuitant time their withdrawals for the best taxing out come, whether that happens to be a year with less income earnings or when significant deductions exist.

  There is also an unfortunate side to the annuity’s tax deferral status: when funds are finally withdrawn they will be taxed as ordinary income (that’s why Roth IRAs are so popular – no taxation upon withdrawal).  If annuity growth was taxed as capital gains, taxation rates would be much lower.  Of course, anything taken out prior to age 59½ will also feel the pinch of the IRS 10% early withdrawal penalty.

  Those who simply must find fault with annuities often bring up the fact that gains are taxed as ordinary income, which tend to have the highest taxing rates.  It really is simply one of the prices investors pay for a secure, low-risk investment.  It is important to note that investors should first make maximum payments to such things as Roth IRAs (if they qualify for one) and 401(k) Plans.  These give tax deferral on gains, like annuities do, but the contributions also reduce the investor’s current taxable income.  Certainly, it makes sense to first contribute to investment vehicles that do that before investing in annuities.

  As we have said, there is no perfect investment vehicle, but by utilizing several in proper order (first investing in IRAs and 401(k) plans, and then investing in such things as annuities) individuals have the opportunity to develop a well rounded plan that will provide adequately during retirement.  For tax purposes, fixed rate annuities can only be compared in terms of safety.  That means comparing them to such things as government bonds or highly rated corporate bonds, which are also taxed at ordinary income tax rates – if held to maturity.  If not held to maturity they could be devaluated.

  There is no point in comparing annuities to 401(k) Plans or other vehicles that are designed differently.  Once again, it would be comparing apples to oranges: both are fruit, but they are very different types of fruit.  Annuities are taxed no worse than other similar types of investment vehicles.

  Lump sum withdrawals are taxed for the year in which they were withdrawn.  When an annuity is annuitized, income is spread over a longer period of time, anywhere from five years to the annuitant’s lifetime.  Payments for lifetime options are based on anticipated life expectancy.  The original premium payments, referred to as the “basis” for tax purposes, are calculated to last until the date of the investor’s life expectancy.  When annuity payments are received each month, part of it is a tax-free return of the original basis and part is the growth that is taxed to the investor as ordinary income.  When the date of the investor’s life expectancy is reached (as used for the basis) all of the premiums have been exhausted.  Therefore, from that point on, the entire systematic payment is taxable as ordinary income.  That sounds like bad news but what it really means is that the investor is now receiving the insurance company’s money rather than his or her own invested principal sums.  In other words, he or she has lived beyond the amount they paid to the annuity company; from that point on, the investor has beat the odds and is collecting money that the investor did not personally save.  Even though it is taxed as ordinary income, it could be viewed as “free” income.  In that perspective, taxation does not seem so bad.

Tax-Deferral Exception

  Not all annuities are tax-deferred.  They must be held for a natural person or in trust for the benefit of a natural person.  An annuity that is held in a corporation, limited partnership, LLC, or other business entity might not be able to grow tax deferred.  Even placing an annuity into a family-limited-partnership might cost the investors their tax deferral status.  In such cases it really makes sense to hire a tax specialist.

Exchanges

  It is often possible to exchange one annuity product for another, although there may be some limitations.  When exchanges are properly executed there are no immediate tax consequences since the investor’s hands do not touch the funds, so to speak.  In some cases, it may even be possible to exchange a life insurance policy for an equity indexed annuity or some other annuity type.  In the case of a life insurance policy, it only works one way: life insurance policy exchanged for an annuity.  It is not typically possible to exchange an annuity for a life insurance policy without causing a taxable event.  These tax-free exchanges are known as 1035 exchanges, for the tax code they come under.  In some cases, the exchange may be partially tax free and partially taxable; this often happens when there is an outstanding loan against the policy.

Annuity Gifts

  Investors must be very careful when a gift is made of an annuity product.  Most professionals strongly advise the investor to consult with a tax specialist in the transaction.  The person who receives the gift may have to pay taxes on the gain on top of any gift taxes required.  Even when annuities are gifted to trusts there could be taxable issues.

  Investors often gift their annuities to charitable organizations.  It is likely the investor will then have to pay taxes on the annuity gains, even though they were given to the charity.  The charitable deduction may offset the taxes, but again a tax expert should be consulted.

Other Tax Issues

  There may be other tax issues that relate to annuities.  For example, estate taxes may apply in some cases.  Since taxation, especially estate taxation, can be so complicated we will not try to address them in this continuing education course.  However, a wise investor will certainly consider all aspects of their investment portfolio.  This applies not only to annuities but to all investment vehicles.

  The purpose of most annuities is to fund the investor’s retirement.  While taxation and estate issues are certainly important they should not cloud the real purpose of saving for retirement.  Annuities are one aspect of saving for retirement; they should be considered primarily for that purpose.  When investors get so side-tracked by other issues that they lose sight of their primary purpose it is difficult to stay focused on saving adequately.  Annuities were designed to provide income for life.

Annuities Might Protect Assets

Generally speaking, annuities are protected assets, which mean that others may not gain access to the accumulations in them.  There are exceptions.  An individual that owes child support, for example, may find him or herself having to give up the annuity values to pay the back child support.  The Internal Revenue Service may also have access to annuity values when back taxes are owed.  Also an investor that pledges his or her annuity as security for a loan has willingly and legally given access to their annuity values if they default on their loan.

  Annuities only have protection from creditors if they were purchased under normal circumstances.  For example, Tom Tardy knows he owes money all over town and those he owes the money to want to be paid.  He receives a large sum of money from a relative and quickly buys an annuity to avoid paying his debts.  This might be considered purchase under fraudulent conditions.  If Tom Tardy gives false information on his annuity application, it could also be considered a purchase under fraudulent conditions.  If Tom Tardy transfers money from an account that does not totally and completely belong to him into his personal annuity that could be considered a fraudulent transfer.

  However, aside from situations that are used to either obtain funds fraudulently or transfer funds fraudulently, annuities are typically safe from creditors.

  Most annuities are not purchased with asset protection in mind; they are purchased as a means of retiring in comfort.  However, many people are involved in occupations that have a high liability, such as physicians, financial planners, and insurance agents.  These occupations are regularly and successfully sued by their clients.  For those in such high-risk occupations annuities should have special appeal: safety from creditors.  It is not possible to transfer funds into an annuity after the lawsuit has been filed, because that would then become a fraudulent transfer.  Annuity investments must be made prior to legal issues.

  It is always important to consider the laws of the domicile state, since annuities are not equally protected in all states.  Some states completely protect a lawfully purchased annuity from all creditors, even during bankruptcy.  The 2005 bankruptcy reform legislation left annuities with that protection, even though many other types of investments suffered changes.

  A better option for financial protection might be use of a trust that lends legal protection to the annuity values and other assets.  Such trusts are not simple documents and may be expensive to have prepared.  Even so, for the physician that knows even good doctors are sued it is worthwhile to do so.  Even good financial planners and insurance agents face lawsuits in this very lawsuit prone society.

  Sometimes annuities are placed in trusts for other reasons.  For example, perhaps the investor’s children have a poor financial history.  He may place his annuities in trust purely for distribution reasons.  The annuity could be directed, upon his death, to pay its proceeds to the trust rather than the beneficiaries.  The trust would then pay out to the beneficiaries as directed by the testator.  There are certain types of trusts that perform very well in specific situations (a spendthrift trust for instance).  Trusts can be drafted by anyone and there are companies knocking on consumer’s doors offering to provide them.  In fact, insurance agents may be in the business of offering revocable living trusts to their clients (attorneys are usually also involved in drafting the documents) but it is seldom wise to accept services of this kind.  Expert, specialized attorneys do not send agents and other salesmen out to knock on consumer’s doors.  Their experience and knowledge bring in sufficient clientele.

Probate

  Annuities bypass probate procedures (although annuity values must still be listed during probate).  Most people are not wealthy enough for probate to be a severe issue, but if the investor believes probate may become slow or cumbersome, annuities may be a good investment choice.  Since they have a beneficiary designation, they go directly to the person or people named in the policy.  The same is true for life insurance policies.  Any type of vehicle that has beneficiary designations may be able to pass the assets on to the named individuals outside of probate.

  Since individuals have individual circumstances, it is very important that an attorney be consulted.  In many cases, both an attorney and a tax specialist should be part of the decision making process.  There are many mistakes that can be made in the attempt to protect assets; whatever it costs to involve these individuals may be well worth the cost.

An Annuity Might be a Bad Idea When:

  Far too many investments are purchased for the wrong reasons.  Maybe Uncle Joe had an annuity that paid well for him so he advocates everyone have them.  Maybe the age restrictions for withdrawal are misunderstood by the young couple wanting to save for a house.  Maybe the agent knew too little and misunderstood too much about the product he sold.  Whatever the reason, annuities are not always the right choice for consumers.

Considering Applicant Age

  Yes, we have said this multiple times, but it is important: withdrawals made prior to age 59½ will incur a 10% Internal Revenue Penalty for early withdrawal.  Annuities were created with retirement in mind, so regardless of whether it happens to be an equity indexed annuity or a traditional fixed annuity, early withdrawal penalties apply.  Most annuity contracts allow for free withdrawals even during surrender periods, but that does not apply to age and the IRS penalties.  Anyone who might need a portion of their money prior to age 59½ should not buy annuities.

Surrender Penalties

  Surrender periods are in annuity contracts to discourage contract surrender for the first seven to ten years; the exact length of the surrender periods will vary among contracts.  Anyone selling or buying an annuity must be well aware of the length of the surrender penalty period.  An investor who anticipates needing the premium paid for the annuity during the surrender period should consider an alternative investment.  Even in the last year when the penalty amount may be only one percent caution is still advised.  If the amount they anticipate needing is small the contracts that allow for surrender-free withdrawals might still work but even then the agent should be cautious in selling the product.  Of course agents must always disclose all possible penalties; agents must ask the investor if he or she anticipates needing any substantial amount during the early withdrawal surrender penalty period.  This comes down to suitability.  Investors who think they might need the money during the surrender years are not suitable for an annuity product in most cases.  This is true of an equity indexed annuity and it is true for a traditional fixed annuity product.

  Some annuities may waive early surrender charges under specified conditions.  This should never be assumed however.  Consult the policy to see if the contract being considered has this feature.  If it does, there will be specific conditions that must first be met.  Look for a heading similar to “Extended Care Waiver” or wording that is substantially the same.  While there may be variations it is likely to say something similar to the following:

“Upon your written request, we will waive the early withdrawal charges that may otherwise apply under your contract to a withdrawal, surrender, or annuitization if at the time of such withdrawal, surrender, or annuitization or within the immediately preceding ninety days of all the following conditions are met:

1. The insured is confined to an extended care facility or hospital;

2. The confinement is prescribed by a physician as being medically necessary;

3. The first day of the confinement was at least one year or more after the effective date of the contract; and

4. The confinement has continued for a period of time that is at least ninety consecutive days.”

  Proof will be required of the confinement and of course that proof must substantiate what the insured has stated.  Proof must be provided prior to withdrawal of funds, never after the fact.

Grasping Fundamental Aspects of the Product

  In all cases with all investments the investor (buyer) must understand what he or she is purchasing.  If the selling agent is a good communicator he or she is probably able to educate the buyer sufficiently.  However, sometimes even good communicators are not able to explain a product in a manner the buyer understands.

  Any time an agent suspects the buyer does not understand the product caution should be used.  A buyer who does not understand what they have purchased is likely to experience “buyer’s remorse.”  Although annuities come with what is called a “free look” period during which he or she can return it for a full refund it is still dangerous for the agent to place any product the buyer does not fully comprehend.  Sometimes it can even result in lawsuits.  Lawsuits are most likely to happen when the product does not perform as the buyer expected it to.  Sometimes lawsuits are filed not by the buyer, but by his or her family members so it is important that the buyer fully appreciate their investment and relay why it was purchased if necessary.

  Consumers buy things every day but most purchases can be touched, felt, and shown off.  When a new car is purchased the family members might not agree with the purchase but at least they understand the reasoning behind it.  An equity indexed annuity is not likely to be shown off as a new car would be.  The buyer may have every confidence in their decision but if the children become involved it could change into a “the-agent-took-advantage-of-my-aging-father” situation.  We are not suggesting that older investors not be allowed to purchase an annuity; all ages have a right to invest in any fashion they wish.  We are advocating that agents take extra time going over the aspects (both good and bad) of the annuity if there is any doubt whatsoever that the product may be misunderstood or if there appear to be lingering doubts about how the product functions.

  Some annuities, such as equity indexed annuities, can be complex, especially to an individual without past annuity experience.  Even agents can misunderstand some annuity characteristics so it stands to reason that many investors will be learning about the product for the first time.  Clear communication is vital to the investor’s satisfaction with the product over many years.  Obviously, it is necessary to disclose all pertinent information about the product prior to the sale.  This is true of all investments.

  Agents must be aware that there always seems to be so-called experts that do not agree with the annuity concept.  Many of these individuals are more interested in selling their books than actually educating the public, but if it causes your clients to doubt their purchase it won’t matter if the author actually knows anything about annuities.  The only way to prevent your clients from doubting their purchase is to cover the product well enough for the buyer to remain satisfied with their decision; remain satisfied even if their children question their buying decision and satisfied enough to ignore the so-called experts hoping to sway them to their personal investing views.

Basic Information Requirements

  There are elements of annuities that agents must completely communicate prior to placing the product.  Some basic information is always necessary:

1. The name and contact information of the issuing insurance company;
2. The name and contact information of the selling agent;
3. The financial rating of the issuing insurance company;
4. The length and amount of the surrender penalties (policy term);
5. The point at which the insured will reach age 59½ and no longer have to be concerned with IRS early distribution penalties.

  In addition to the basic information listed above, equity index annuity investors need to know:

1. The minimum guaranteed rate of interest gain;
2. The participation rate for interest crediting;
3. How the annuity is linked to the index;
4. The participation rate for index crediting;
5. Any caps that exist in the contract;
6. How the insurer will treat the annuity if the insured dies (are surrender charges waived for example);
7. Are there exchange options?  If so, what are they?
8. Can the insurer change some terms in the contract (often called the “moving parts”)?  If terms can be changed, specifically what may be changed?  Insurers can typically change guaranteed interest rates at specified points, but there may be other terms that are changeable as well.
9. Tax consequences that may apply to the annuity must be known, such as taxation as ordinary income when funds are withdrawn.  There may be tax matters that are specific to an individual so agents are wise to suggest buyers consult their personal tax accountant.

  There may be additional points the agent feels are important to discuss with their clients.

  Annuities, including equity indexed annuities, are primarily regulated by the individual state insurance departments with some differences in regulation existing among the states.  Even so, the states primarily have similar requirements.  Equity indexed annuities are not subject to SEC regulation since they are not securities.  Therefore, EIAs are not subject to customer suitability, disclosure and sales practices requirements that registered securities must meet.

Terminology for Equity Indexed Annuity Products

  Most agents are accustomed to specific product terminology but equity indexed annuities are not like the traditional fixed rate annuities so there may be terms the agent is not already familiar with, but that are very important to know.  These include:

Adjusted Change: The change in the Index Value for a segment, with adjustments as described in the indexed interest rate provision.

Annual Reset Indexing Method: Index-linked interest, if any, is determined each year by comparing the index value at the end of the contract year with the index value at the start of the year.  Interest is added to the annuity each year during the term.

Annuity Benefit: The payments that may be made under the “benefit on annuity commencement date” of the contract.

Averaging: Some annuities use an average of an index’s value rather than the actual value of the index on a specified date.  The index averaging may occur at the beginning, the end, or throughout the entire annuity term.

Beneficiary/Beneficiaries: The person or people entitled to receive death benefits if the annuitant should die prior to withdrawing all annuity funds, unless annuitized for a lifetime benefit, in which case beneficiaries receive nothing even if the annuitant did not use all premiums deposited.

Cap or Cap Rate: Some contracts will state an upper limit, called a cap, on the index-linked interest rate.  This is the maximum rate of interest the annuity will earn.  It is the highest Adjusted Change for each segment of the indexed strategy.

Code: The Internal Revenue Code of 1986, as amended, and the rules and regulations that are issued under it.

Commencement Date: The annuity commencement date if an annuity benefit is payable; the death benefit commencement date will be shown on the contract specifications page.

Contract Anniversary Date: the date each year that is the annual anniversary of the contract effective date, shown on the contract specifications page.

Contract Year: A contract year is each twelve (12) month period that begins on the contract effective date or on the contract anniversary.

Death Benefit Commencement Date: the first day of the first payment interval for a death benefit that is paid as periodic payments or the date of payment that is paid as a lump sum if periodic payments will not be made.

Death Benefit Valuation Date: Although contracts may vary, typically it is the earlier of:

1. The date that the insurer has received both Due Proof of Death and a written request with instructions as to the form of death benefit (lump sum or systematic payment); or
2. One year form the actual date of death.

Due Proof of Death: Due proof of death is typically one of the following:

1. A certified copy of a death certificate, or
2. A certified copy of a decree that is made by a court of competent jurisdiction as to the findings of death (this is generally only used when the person or person’s body cannot be located).  Companies may accept other types of proof in some circumstances.

Floor: The lowest Adjusted Change for each segment of an index strategy is called the “floor.”  It is the lowest point on equity index-linked interest.  It is the minimum index-linked interest rate the investor will earn.  The most common floor is 0% (zero).  While that looks like a bad thing, it actually assures that even if the index decreases in value, the index-linked interest will not go negative, losing money.  Yes, no interest would be earned but neither would any principal be lost.  Not all contracts have a stated floor on index-linked interest rates but fixed annuities will have a minimum guaranteed value.

High-Water Mark Indexing Method: The index-linked interest, if any, is decided by looking at the index value at various points during the term, typically the yearly anniversary date of purchase.  The interest is based on the differences between the highest index value and the index value at the start of the term.  Interest is added to the annuity at the end of the term.

Index: An index is the specified index that will apply to an Indexed Strategy for the term shown in the equity indexed annuity contract, usually on the specifications page.  If the index is no longer published or its calculation is changed, the insurer may substitute a suitable index at their discretion.  Insurers should notify their policyholders if a substitution is made.  Sometimes the insurers are required to first get approval of the substitution from the state insurance department.

Index Value: The index value is the standard industry value of the index.  The index value for a particular date is the value of the index as of the close of business on that date.  For any date that the New York stock Exchange is not open for business, the index value will be determined by the insurer and stated in the policy, but often it is the index as of the close of business on the most recent day on which the Exchange was open prior to that date.

Indexing Method: 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 include annual reset, or ratcheting method, high-water mark method and the point-to-point method.

Index Spread: An amount by which the Index Change is reduced when computing the Adjusted Change.

Index Term: The index term is the period over which index-linked interest is calculated.  In most product designs, interest is credited to the annuity at the end of the term, which may be ten years although the average term is more likely around seven years.  Products may offer a single term or multiple consecutive terms.  Those with multiple terms usually have a window at the end of each (generally 30 days) during which the policyowner can withdraw his or her funds without penalty.  For installment premium annuities, the payment of each premium may begin a new term for that premium.

Index Value: The standard industry value of the index is the index value.  The index value for a particular date is the value of the index as of the close of business on that date or the most recent date the Exchange was open.

Interest Compounding: Some annuities pay simple interest during an index term.  That means index-linked interest is added to the original premium amount but it does not compound during the term.  Others pay compound interest during a term so that the index-linked interest hat has already been credited earns additional interest.  In either case the interest earned in one term is usually compounded in the next however.

Participation Rate: The participation rate is the portion of the index change that is used to compute the adjusted change.  It decides how much of the increase in the index will be used to calculate index-linked interest.  It is the portion of the index change that is used to compute the Adjusted Change.  Note the definition of “adjusted change” above.  Participation rates are typically guaranteed for stated amount of time, but the company will change the rates after that time.

Point-to-Point Indexing Method: The index-linked interest, if any, is based on the difference between the index value at the end of the term and the index value at the start of the term.  Interest is added to the annuity at the end of the term.

Segment: Segment is the period of time over which the change in the index is measured for an indexed strategy.  A segment may never be longer than the term of that strategy.  The initial segment begins on the first day of the term.  Subsequent segments begin upon the expiration of the preceding segment.  Daily segments that end on a day that the New York Stock Exchange is closed are often disregarded.

Term: For a declared rate strategy, the period of time during which the interest rate is declared; for an indexed strategy, the period over which an indexed interest rate is calculated.  The initial term begins on the first interest strategy application date.  Subsequent terms begin upon the expiration of the preceding term.

Valuation Date: A date on which the index value is measured to compute the Index Change.  If an indexed strategy uses valuation dates that are daily, then dates on which the New York Stock Exchange is closed are disregarded.  If an indexed strategy uses valuations dates that are other than daily, the valuation dates are the dates within a month that correspond with the first day of the term.

Vesting: Some annuities do not credit any of the index-linked interest, or only part of it, if the investor withdraws their money before the end of the term.  The percentage that is vested, or credited, generally increases as the term comes closer to its end and is always 100% vested by the end of the term.

General Contract Provisions

  All contracts have general provisions.  In life and annuity insurance policies the general provisions establish what might be called the “ground rules.”  The following is a sampling of what might be seen in an annuity policy.  In our example we have used an equity indexed contract since they are typically more complex than the traditional fixed rate annuity product.  However, it is important that all agents review a copy of the product, whether it is an equity product, a traditional annuity, or a variable product.

Entire Contract

  The contract must be identified.  It might state something similar to: “This Contract is an individual deferred annuity contract.  It provides for both declared and indexed interest rates.  It is restricted as required to obtain favorable tax treatment under the Code.  This contract, any riders or endorsements to it, and the application for it, if any, form the entire contract between the owner and the issuing insurer.”

Changes and/or Waivers

  The contract is always the final word on the terms and conditions of the annuity.  Agents do not have any authority to make changes or waive any part of the contract.  The policy will state this in wording similar to the following:

  “No changes or waivers of the terms of this contract are valid unless made in writing and are signed by the insurer’s President, Vice President, or Secretary.  No other person or producer, including the writing agent, has any authority to change or waive any provision of this contract.  The insurer reserves the right both to administer and to change the terms of this contract to conform to pertinent laws and government regulations and rulings.”

Misstatements

  We usually think of misstatements in terms of age but it can relate to any misstatement.  Some errors affect the performance of the policy while others have little effect.  Often misstatements change the premium cost of the policy but annuities typically do not have this concern since they are based on the amount earning interest, usually not the age of the insured.  In some cases, age does have a bearing however since many annuities will not issue coverage to anyone above a specified age.  Misstated age can also affect the amount of systematic payments upon annuitization since age is a major factor is determining projected length and amount of those payments.

  Most policies address the issue of misstatements.  In an equity indexed annuity it might read similar to the following:

  “If the age of a person is misstated, payments shall be adjusted to the amount that would have been payable based on the correct age.  If payments based on the correct age would have been higher, we (the insurer) will immediately pay the underpaid amount in one sum, with interest, at the rate of __% per year.  If payments based on the correct age would have been lower, we (the insurer) may deduct the overpaid amount, with interest at a rate of __% per year, from succeeding payments and pursue other remedies at law or in equity.”

  Of course, the interest rate will be filled in, but for our example we felt it best to leave it blank.

Required Reporting

  The state insurance departments probably have some requirement for notifying clients of changes in policy status or earnings.  Policies will state how often such reports will be issued to their policyholders.  Generally companies notify at least yearly of changes that will affect their policyowners.  The policy will state how reporting may be expected.  It might read similar to the following:

  “At least once each contract year, we (the insurer) will send you a report of your current values.  We (the insurer) will also provide any other information required by law.  These reports will stop on the earliest of the following dates:

1. The date that this contract is fully surrendered;
2. The annuity commencement date; or
3. The death benefit valuation date.

  The reports will be mailed to the policyowner’s last known address.  If permitted by law, in lieu of that we may deliver these and other required documents in electronic form.  The reported values will be based on the information in our possession at the time that we prepare the report.  We may adjust the reported values at a later date if that information proves to be incorrect or has changed.”

State Law

  Certainly, states may have laws in place that affects how the annuity contract may be written and laws change from time to time.  It stands to reason that insurance companies must follow whatever laws are in place and any laws that come after the contract was written, if they affect the contract.  There is likely to be some statement in the equity indexed annuity regarding state laws; it may read similar to the following:

  “All factors, values, benefits, and reserves under this contract will not be less than those required by the laws of the state in which this contract was delivered.”

Claims of Creditors

  Some states will better protect against creditors than others.  Your annuity will follow what ever the state dictates by law.  It may be stated as the following: “To the extent allowed by law, this contract and all values and benefits under it are not subject to the claims of creditors or to legal process.”

  The important part of that statement is “to the extent allowed by law.”  At any point creditors become an issue the insured should obtain legal advice from a competent attorney that specializes in contracts or consumer law.  Since laws do sometimes change the policyowner should not rely on information obtained at an earlier date.

Other Contract Items

  There will be other items covered in most contracts, such as Exclusive Benefit (who may benefit from the contract), liability issues, tax issues, incontestability and transfer by the company.  In all cases, agents must be fully aware of the products they are representing and selling.  Of course, applicants have a responsibility to fully read the contracts but as every agent knows, they seldom do.  Instead, they rely upon their agent to fully disclose all facts and figures.

  Even when an insurance producer believes he or she has fully disclosed all relevant facts and features of the product, there is no way to keep the information fresh in the buyer’s mind.  Since agents do not want lawsuits simply because the consumer forgot what he or she was told it is the wise agent who delivers the policy personally and goes over the features a second time.  It is an even wiser agent who obtains the buyer’s initials on all key points within the policy.  This can be done on a separate paper or form that the agent keeps in the client’s file at the producer’s office.  Having the policy initialed is fine as long as the agent has access to it in case of a lawsuit, but that is unlikely.

Additional Payments

  Some annuities will allow only one initial payment; others will allow additional payments.  Too often insurance producers do not think to inquire whether buyers might wish to make additional payments in the future.  It is an important question to ask since the buyer might simply assume he or she can do so.

  When a contract allows additional premiums (deposits) it will specifically state so.  The heading might vary, but should say something similar to “Purchase Payments” or “Additional Premium Payments.”  If additional premium payments are allowed it will state something similar to the following:

  “One or more purchase payments may be paid to us (the insurer) at any time before the annuity commencement date, so long as you (the buyer) are still living and the contract has not been fully surrendered or annuitized.”

  Since annuitization locks in payments it would not be possible to make additional payments once annuitization was initiated.

  Most equity indexed annuities have minimum premium deposit requirements.  Many have a $10,000 initial deposit requirement, but that can vary even among policies of the same company.  Traditional fixed rate annuities may also have minimum initial payments.  Since this varies among products, agents can often find a product that suits the needs of the buyer.

  Some contracts may offer a purchase payment bonus.  If so, it will be specifically stated in the contract.

Stranger-Originated Annuity Transactions (STAT)

  A STAT involves a transaction for the purpose of financially gaining from the death of an annuitant.  A stranger originated annuity transaction occurs when an investor approaches a terminally ill patient and offers to pay them for use of their identity in an investment annuity.  It is similar to stranger-originated life insurance transactions utilized in the life insurance industry where life insurance is taken out on terminally ill persons.  The individual used as the annuitant is usually a complete stranger to the investor, and not expected to live for longer than a year.  In some cases, they may find the target by approaching elderly individuals in the nursing home or in hospice care.

  The investor then sets up an annuity transaction in the patient’s name, ensuring that the policy guarantees a minimum payout in the event of the patient’s death.  In order to keep from being discovered, the investor will usually ensure that the guaranteed minimum death benefit falls below an amount that would violate certain underwriting guidelines.  The investor also names an organization as the beneficiary, rather than their personal identity, in order to avoid being exposed.  Obviously this practice is not considered ethical and could even be illegal since the issuing insurer does not know the actual circumstances of the application.

  Ethical professionals do not generally favor use of STATs often voice opposition to the growing use of the practice.  Many insurance trade groups have formally stated their opposition to the practice.

  The National Association of Insurance and Financial Advisors (NAIFA), representing about 200,000 agents and financial service professionals, voted to oppose the transactions several weeks ahead of a National Association of Insurance Commissioners (NAIC) public hearing May 20, 2010 to investigate the practice.  The National Conference of Insurance Legislators may begin investigating STATs at some point.

  In both stranger-originated life insurance (STOLI) transactions and stranger-originated annuity transactions (STAT), the policy application is initiated for the benefit of an investor who has no relation to the person whose life the insurance policy or annuity is based upon.  When the transaction is completed, neither the insured nor his or her beneficiaries will have any further legal interest in the policy or annuity’s benefits.  As with STOLI transactions, many STAT transactions are not being initiated for a typical or historically legitimate insurance purpose.

  Thomas R. Sullivan, the Connecticut insurance commissioner and head of the NAIC Life Insurance and Annuity Committee, initiated the May 20th public hearing so the NAIC could learn more about stranger-oriented annuity transactions.  The NAIC represents state insurance commissioners and are often the individuals who enact certain practices to protect consumers.  Obviously targeting elderly Americans and terminally ill individuals with the promise of payment for taking out these policies raise some serious questions.  Insurers must have full disclosure in order to properly underwrite the risks that insurance policies represent.  If numerous applications represent risks the insurers are not aware of that will eventually affect all policyholders as insurers pay out artificially high death proceeds.  STATs are not for the insured individuals and their beneficiaries but rather for the benefit of investors and intermediaries.

  There are many questions surrounding the use of life and annuity transactions that benefit primarily investors and intermediaries.  It is likely that similar regulation as those in the viatical life insurance industry will follow for annuity products.  All insurance transactions must, of course, be legal and follow current model laws and regulations.

  Like stranger originated life insurance transactions (STOLI), producers or investors offer a stranger a nominal fee for the use of their identity as the measuring life on an annuity.  While fixed annuities have not typically been used, some instances of deferred bonus annuities have been.  Usually, the individuals targeted to serve as annuitants are in extremely poor health and are not expected to live beyond the first year of the policy.  In order to find individuals who meet the above criteria, producers and/or investors have been known to take out advertisements in papers as well as solicit individuals residing in nursing homes or hospice care.

  Once the individual has agreed to the proposal, the producer or registered representative will complete the annuity application, ensuring particular features, such as a bonus rider or a guaranteed minimum death benefit, to facilitate a specific rate of return for those financing the annuity purchase.  Depending on the number of companies represented and the commission policies in effect, producers or registered representatives may purchase multiple policies from multiple companies or use a variety of techniques to fly under the insurer’s underwriting radar.

  To avoid added insurer scrutiny of the submitted application or detection of the actual goal, producers and registered representatives often take precautions to ensure the annuity dollar amount falls below specific underwriting guidelines or policy maximums.  A trust or an organization will probably be named as beneficiary of the annuity in order to hide the true identity of those who will benefit from the annuitant's death.

  Financial implications of stranger originated annuity transactions can be detrimental to the industry as well as consumers.  NAFA suggests that insurance companies and marketing organizations protect customers by:

· Reviewing chargeback policies to ensure producer/registered representative commissions are adjusted if a policy is annuitized within the first year of the contract.

· Creating detection methods to identify producer/registered representatives who may be involved in the facilitation of stranger originated annuity transactions.

· Ensuring annuity applications conform to suitability review guidelines and the suitability review process creates red flags that identify questionable applications and refers them for additional review.

· Reporting potential stranger originated annuity transactions to the appropriate Department of Insurance.

  As we know, annuities protect consumers by offering guaranteed benefits, including death benefits and income for life.  Since investors are seeking terminally ill consumers to act as annuitants the annuities are being used as a wagering contract on the annuitant’s death.  Clearly that is not the insurer’s intent when they issue the contracts.  Those who encourage application of the contracts are aware of that or they would not be taking such great measures to hide their intentions.

  Most annuities are purchased for the traditional reasons, not to benefit an investor, and are therefore legal.  The current NAIC Suitability in Annuity Transactions Model Regulation or some version of it has been adopted in most states.  This and the NAIC Disclosure Model Regulation provide a framework for carriers to obtain information to identify sales that are unsuitable and do not benefit the consumer.  With the heightened awareness of the use of annuities by investors to wager on the death of annuitants, carriers, as well as producers, have some tools to prevent these sales but it is often more difficult than merely following standard procedures.

  Currently it is unclear if applicants have fully understood the transactions they participated in.  Since they are terminally ill, their need for income is often great and make it likely that they do not care if they fully understand what is going on.  In life insurance transactions, insureds sell their contracts for a portion of the death benefit; the quicker the individual dies the more investors earn.  The longer the insured lives, the less the investors earn because premiums must continue to be paid.  In the annuity field, there are no continued premiums so investors have a greater capability for gain.   Selling their life insurance policies allowed policyholders to receive money they might not otherwise have had access to.  If the policy was purchased prior to the terminal diagnosis then there is nothing wrong with selling their insurance contracts to an investor.  If, however, the terminal illness was known at the time of application there are many ethical and legal questions involved.  For example, was the insurer aware of the applicant’s pending death?  It seems unlikely an insurer would issue a policy on an individual that has an expected date of death.

  In a STAT transaction an unrelated investor is the buyer and owner of an annuity purchased on the life of a terminally ill person.  Generally, a variable annuity is purchased but indexed annuities are also a possible choice.  Traditional fixed annuities do not perform sufficiently to be used in a stranger-originated annuity transaction.  Since the investor is looking for a good profit, fixed rate annuities are not generally the type of annuity chosen.  Investors want annuities that might perform well in the market and traditional fixed rate annuities have no ability to earn based on market performance.  According to NAIFA, the terminally ill annuitant typically receives an up-front payment ranging from $2,000 to $10,000 for participating in the transaction, and receives no further payment or benefits from the transaction.

  The annuity contains a guaranteed death benefit rider (GDB) which guarantees that at the time of death, the owner/beneficiary will receive at least as much as was invested in the annuity, and possibly more depending on market performance and the terms of the rider.  Because of the protection provided by the GDB, the investor/owner will likely choose more speculative sub-accounts as the investment vehicles for the STAT.  If the market performs well, the investor will benefit from the account’s performance; if the market does not do well, the investor’s investment is protected by the minimum return guaranteed by the GDB.

  Since this could appear to be good for both the terminally ill individual and the investor one might think it is merely a good investment avenue.  However, in order for the insurance industry to continue performing well the insurance companies issuing these products must be able to correctly assess their risk.  That is not possible in the case of STATs because the insurer is likely to lose over and over again.  Eventually the insurers must raise the costs of insurance for everyone.  Clearly it is not the intention of insurers to issue policies that are likely to create losses for the issuing companies.  There is also concern that the annuitants are not aware of all these contracts involve.  They may not be aware of their own liability when they state false information on the application or if they fail to disclose known medical information.

This Completes Your Reading Material

  This completes your reading material.  Annuities range from simple fixed-rate products to the riskier variable annuity products. Agents who market annuities must understand all annuities to some degree, but especially the particular projects the agent represents.

United Insurance Educators, Inc.

PO Box 1030

Eatonville, WA 98328

Email: mail@uiece.com

Website: www.uiece.com

---

[1] iUniverse, Inc. New York Lincoln Shanghai, Copyright 2006