Chapter 4

 

Annuity Contract Provisions

 

 

Common Provisions of Annuities

 

Annuities have been around, in some form, for over a century. There have been years where the growth of annuities has been greater than that of mutual funds. Annuities provide tax-deferred growth guarantees, professional management, safety, flexibility, growth, and the option of having a monthly income once annuitized.

 

For Americans who want safety, annuities offer a valuable financial vehicle. The investor may decide how their money is invested and for how long. A rate of return can be locked in that ranges from three months up to ten years. The portfolio may be invested in stocks, bonds, or money market instruments. There is no requirement in non-qualified annuities that money be removed during the owners lifetime or the lifetime of the spouse. At the same time, part of the interest growth and principal may be withdrawn. Any account balance that remains in a non-annuitized annuity will pass on to the beneficiaries following the owners death. Even in annuitized contracts, it is possible that beneficiaries may be able to inherit, depending upon the annuitization form selected.

 

There is no limit to the amount of money that can be invested in an annuity. A person may invest a single, lump-sum amount, or make periodic or sporadic investments. Annuities may be either qualified or non-qualified investment vehicles. Anyone can use an annuity; there are no requirements regarding annual income.

 

The type of annuity selected will determine range of investment safety (risk level). They are available from extremely safe and conservative to high risk. It is possible to target certain investment segments or stick with more traditional areas of investing such as government bonds or growth stocks.

 

Annuities are always made through an insurance company even if the paperwork is filled out at a bank, attorneys office, accountants office, or at the investors kitchen table by an insurance agent. It is a contractual agreement between the investor and the insurer. Even though an annuity is an insurance product, it has little in common with life insurance, and even less in common with other forms of insurance.

 

In Summary

 

         There are two types of annuities: fixed and variable. Other annuities fall under one of these two categories.

         Both variable and fixed offer tax-deferred growth, professional money management, owner control, liquidity, lifetime income options, safety, avoidance of probate, and guaranteed death benefits.

         Combined taxation by federal and state governments has made annuities attractive to consumers. Contributions to purchase nonqualified annuities are not tax-deductible, so there is no limit on how much may be deposited.

         Distribution is not required at any particular age. In fact, it is not required that distribution occur at all.

 

Annuity Types

 

There are different types of annuities, each designed to fulfill a specific type of need. This would include fixed rate annuities, where the investor receives a set rate of return; variable annuities, where the investor has no set rate of return and a choice of one or more portfolio subaccounts in which to invest; flexible premium annuities, where the investor has the option of adding money to an existing contract; a single premium annuity, where only one deposit may be made; immediate annuities that begin paying the investor an income immediately, and deferred annuities that wait until a later date to begin providing the contract owner with an income.

 

There are four parties involved in an annuity: the insurer who issues the contract, the owner, who invests in the annuity and owns the contract, the annuitant, who may be the same person as the owner, but does not necessarily have to be, and the beneficiary who is named to inherit unused funds in the event of the annuitants death.

 

There are additional types of annuities, but they are typically classified as types of the basic annuities. These would include equity-indexed annuities (EIA), charitable gift annuities, joint-and-last-survivor annuities, private annuities, and split annuities to name some of the varieties available.

 

Provisions Affect Consumers

 

When consumers take their automobile to the dealer, he or she is likely to ask many questions regarding price, services, and timetables. Yet, the same consumer will plunk thousands of dollars down on an annuity and ask very few questions. Why is this?

 

The answer isnt difficult to understand. The consumer feels confident asking questions about his automobile, but he feels intimidated by the annuity contract. Contracts must be in legal language, so they can cause a consumer to feel threatened before he or she even tries to understand them. Since people do not want to appear stupid or uneducated, they will say or ask nothing rather than appear in an unfavorable light.

 

Annuities are actually not difficult to understand. However, if the agent does not learn to communicate well, the prospective buyer may not realize that he or she can easily understand the product. An annuity is an investment made through an insurance company. That is true whether it is purchased from an agent that comes to the consumers home or from an agent at the local bank in town. Even though a bank employee may be selling the annuity, that person still must earn and maintain an insurance license.

 

When an annuity is purchased, specific guarantees or promises are contractually made. These promises will depend upon the type of product selected and upon the company issuing the investment (annuity). There are three primary ways to categorize an annuity:

 

         How is the money invested? It will be either fixed rate or variable rate.

         When is income wanted? Immediately or at a later date?

         Can additional deposits be made to the annuity? If they can be, they are flexible premium annuities. If no additional deposits may be made, they are single premium annuities.

 

Each element of the three categories of annuities is a contract provision. Therefore, they affect how the annuity performs and what the owner may expect from them.

 

Interest Rates

 

Annuity contracts promise to pay a specified amount of interest on the money deposited. There are several interest rates involved: the guaranteed lowest rate, the current rate, and sometimes an initial rate.

 

The guaranteed rate applies to the least amount that will be paid. Not all contracts will be the same, but most are essentially the same on minimum guarantees. The minimum guaranteed interest rate promises each policyholder that no less than a stated amount will be earned by the money deposited (it could be more, but never less). The guaranteed rate of an annuity contract will be defined in the contract. The current rate will not be. The current interest rate is typically higher than the guaranteed rate because the current rate is based upon some specific indicator that may or may not be stated in the policy. The insurer is not required to pay a higher current rate. In the low rates of the last few years, current rates and guaranteed rates may be the same figure. The current rate is not contractual and is established by the insurance companys board of directors. It will vary based upon many factors, including the companys needs. Usually, a higher current rate is given to establish marketing objectives.

 

The guaranteed interest rate will be guaranteed contractually.

Current rates are not guaranteed.

 

 

First Year Incentive Rates

Some annuities offer a higher first year interest rate, called an incentive rate. Inside industry people may call this a teaser rate. Seldom would the teaser term be used with consumers since it obviously indicates a marketing strategy. This is not to say that a teaser rate is either good or bad, but it is important to look at the contract as a whole. Too often a first year incentive rate means lower than necessary rates in the following years. An annuity with a teaser rate may guarantee a rate during the first year that is better than that being offered elsewhere, but the consumer discovers in the second contract year that the rate has dropped below other investments of similar type.

 

An agent that is uncertain which product is best for the consumer has a simple way of determining it: simply look at the commissions being offered. If the commissions are higher on one product than all others from the same insurer, there is likely a good reason: the company wants agents to market that particular product. Why would an insurer want one product marketed over another? It may have something to do with the profitability. It would be unfair to insurers to imply that they are putting out bad products, especially since just about any product works well somewhere. However, it is probably true that most companies, not just insurers, are going to promote that which brings in the most profit. It would make little sense to spend advertising dollars to promote a product that is not profitable. As long as agents realize this, they will be equipped to look at the available products from a realistic standpoint. Your clients will potentially depend upon you for many years and your reputation will hinge on the products you sell. Therefore, it is important to take a realistic view of the companies you choose to represent.

 

Bonus Credits

Some insurers offer bonus credits in their variable annuities. These contracts promise to add a bonus to the contract value based on a specified percentage, usually ranging from 1% to 5% of the purchase payments. For example, a bonus credit of 3% would add $600 to a purchase payment of $20,000 for an annuity. The consumer will want to note whether the bonus credit applies only to the first deposit premium or to multiple premiums.

 

It is important to realize that any additional feature is likely to carry additional costs as well. Variable annuities offering bonus credits may charge expenses that outweigh the amount of the bonus credit. There may be higher surrender charges, longer surrender periods, or higher mortality and expense risk charges. It is important to look at the differences between an annuity without a bonus credit and one with it. The consumer must decide whether the bonus is worth any differences that result.

 

Some annuity contracts have the right to withdraw the bonus credits. This could happen for a number of reasons, which will be specified in the contract. Some withdraw the credits if the contract owner makes a withdrawal, if a death benefit is paid to beneficiaries or other specified circumstances.

 

It is not unusual for an agent to urge a consumer to exchange an existing annuity for one with bonus credits. This is not necessarily a wise move. If the surrender period on the current annuity has expired, exchanging it means a new surrender penalty will exist. This will affect ability to withdraw cash without penalty and may mean higher fees in other areas.

 

Financial professionals who sell annuities, particularly variable annuities, have a duty to advise their clients as to whether or not the product they are suggesting is suitable to the individuals particular investment needs. Although there is a free look period, most consumers rely on the professionals opinion.

 

Interest Rate Strategies

 

How the interest rate is added can vary among annuities, even within the same company. The two most common methods used to determine the current interest rate to be credited to employees accounts are the portfolio average and the banding method. The portfolio average method reflects the insureds earnings on its entire portfolio during the given year. All policy owners are credited with a single composite rate.

 

The banding method uses a year-by-year means of crediting accounts. Contributions are banded together for that particular year. Each account is credited with the yield such monies actually earn. The banding method is advantageous to the investor when interest rates are rising. In a decline rate environment, however, the portfolio method is best.

 

It would be misleading to compare the current rate of return between companies using different methods of interest accumulation.

 

Some companies use a calendar-year approach in valuing the rate of interest to be credited. These companies use a quarterly, monthly, or even daily accumulation method. The reasoning behind this more responsive method is to allow the insurers to be more competitive and also to move quickly to alter the credited rate if it is too high in relation to the actual yield on the companys portfolio.

 

Some insurers use a provision called market value adjustment. This method adjusts the accumulated fund balance, not the yield, upward or downward. The adjustment is in the opposite direction of the movement in interest rates. If the current rate were higher for new contributions, the value of the investors account would decrease. On the other hand, a decrease in the current rate results in an increase in fund value. Therefore, accumulated monies can constantly change in value, even though an individual invested in a fixed-rate vehicle.

 

 

Issue Ages

 

Most types of contracts deal with age of the participants. In annuities, there may be a minimum age as well as a maximum age. Sometimes the age limitations come from the insurers who choose not to issue some contracts outside of specified parameters for underwriting reasons. The measuring life of the annuitant would be a reason that an insurer might choose not to issue an annuity on individuals over age 80, for example.

 

In other cases, age restrictions come from state insurance codes. California Insurance code 10112 (referring to Probate Code) issues specific requirements for younger ages. It states, in brief, that a person under the age of 18 may not automatically be considered incompetent to exercise all of his or her rights under the contract. That would include the ability to seek out an annuity, surrender the contract, or exercise any other right available, although the insurer may request the approval of the parent or guardian. If the individual is age 16 or younger, he or she must obtain written consent of a parent or guardian to exercise any rights, including surrender, under the annuity.

 

This is true for both those under 18 and those under 16 even if the benefits of the minor are for the benefit of his or her father, mother, sibling or any other family member or non-family member.

 

Contracts made by a minor (not yet 18 years old), that might result in any personal liability for assessment must have the written assumption of any possible liability by his or her parent or guardian. That means the parent or guardian would have to assume any liability that cannot be legally assumed by the minor. That liability would have to be stated in writing by the parent or guardian, so that it may be proven they were aware of the liability they were assuming. The liability assumption must be on a form developed and approved by the California Insurance Commissioner. The insurer may require their own liability form, in addition to the one supplied by California, if they wish. The liability assumed by the parent or guardian would cease when the annuitant reached the policy anniversary date following their eighteenth birthday.

 

Crisis Waivers

 

A crisis waiver may be known by several names, including hardship clauses and medical waivers. Contracts that include these allowances will release funds to the annuitant or policy owner (depending upon the terms of the policy) for use in specific circumstances. Some situations that would allow release of funds include admission to a nursing home for more than a specified time period (often six months), a terminal illness, unemployment, or disability. Since contract terms will dictate the terms of releasing the owner from the contract terms, it is important to fully read and understand these provisions.

 

It is important to realize that additional benefits nearly always carry additional charges to the consumer. Agents have a responsibility to alert their clients to any additional charges that waivers and other features add.

 

Premium Payment

 

Obviously, no annuity contract will be effective if it is not funded. Under CIC 10540, incorporated life insurers issuing life insurance policies on the reserve basis may collect premiums in advance. They may also accept money for the payment of future premiums related to any policies that have been issued. Insurers may not accept money in any amount that exceeds the sum of future unpaid premiums on any policy or the sum of 10 such future unpaid annual premiums on a policy if the sum is less than the sum of future unpaid premiums for the policy. This would not limit the right of insurers to accept funds under an agreement that provides for accumulation of funds for the purpose of purchasing annuities at some future date.

 

Some types of annuities allow the owner to add money, called premium, to existing annuities (flexible premium annuities). Therefore, there could be future premium payments. Virtually all variable annuities are flexible premium annuities. If the contract allows only a single, onetime investment, it is called a single premium annuity because a single premium payment is made. Investors would not be able to add premium (additional deposits) to this type of annuity. Rather, they would have to fill out a new application and accept whatever interest rate was currently available. There is no particular disadvantage to having multiple annuities and many investors do so. In fact, since most Certificates of Deposit operate this way, investors often feel comfortable with the concept.

 

Annuity Settlement Options

 

Few annuity contracts require the contract owner to annuitize their annuity. Statistically, many never do. However, annuities were developed to be annuitized and by doing so provide an income for an extended period of time. When the owner does choose to annuitize their contract, just prior to annuitization, he or she must select a period of time over which it will distribute funds.

 

Annuitization should never be taken lightly. How the contract is distributed can affect all concerned. Depending upon the insurer, annuitization can take place over one of the following periods: life only, joint and last survivor, lifetime with period certain, and a set number of years or dollar amount.

1.    Single Life: For as long as the annuitant lives he or she will receive a check each month for a specified sum of money. The annuitant is considered to be the measuring life. The amount to be received each month will never change. This option will pay the maximum amount in comparison to the other options. This option involves a gamble. If the annuitant lives a long time, he or she may collect handsomely over the length of their life perhaps far more than ever paid into the annuity. However, if the annuitant dies sooner than expected the insurance company will keep any balance left unpaid. No leftover funds will be distributed to any beneficiaries.

2.    Joint-and-Last-Survivor: Under this option, the insurance company will make monthly payments for as long as either of two named people lives. Married couples often utilize this option. However, the couple need not be married. The insurance company will honor any two people named so, besides a husband and wife, it could also be a father and son, sister and brother, or two unrelated people. The insurer considers the ages of both people when determining monthly income. Checks are not stalled or altered after the death of the first person. The same amount continues to be sent out until the death of the survivor, regardless of whether that person is the spouse, son, daughter, friend, or other person, as long as he or she were one of the two named individuals in the contract.

Some contracts are structured so that the monthly income is higher while both named individuals are living, and decrease by a specified amount after one of the two have died. When the contract distributes in this manner, annuity payments would likely be higher, since the insurer would pay out less over the lifetime of the payout period.

Obviously, as in the life option, one could say that the insurance company is hoping for the early death of both annuity participants. It would have to be the death of both, since the death of just one would not stop payout. Once both have died, all payout stops. Nothing would continue on to any named beneficiary.

3.    Lifetime with Period Certain: This may also be called Life and Installments Certain. Either way, the key word here is certain. The "certain" period of time is usually either ten or twenty years, but may be another time period also. This option states that should the annuitant die prior to the stated "certain" time period, payments would then continue to the beneficiary until that specified number of years had been met. On the other hand, the annuitant may receive payments longer than the "certain" period stated. The Lifetime guarantee insures that the annuitant will receive a specified monthly payment for the duration of his or her lifetime. The amount received will not be as high as it would have been in a straight Life Option, since the insurer has to make a second guarantee for the period certain. It is important to note that the stated time period (Period Certain) begins from the first month of annuitization not from the time of the annuitants death. Therefore, if the Period Certain is ten years, for example, and the annuitant lives for exactly nine years, then the beneficiary would receive just that one remaining year of benefits.

4.    Cash Refund Annuity: This option refers to the specified number of years or specified dollar amount option. If the annuitant dies before the insurance company has paid out the amount invested, then the remainder of the invested money (plus interest) will be paid out in monthly installments or in a lump sum to the named beneficiary or beneficiaries.

 

In each of these options, the insurance company pays nothing beyond the agreed period of time or agreed dollar amount:

1.    Single Life = nothing after the death of the annuitant;

2.    Joint-and-Last-Survivor = nothing after BOTH named people have died;

3.    Lifetime With Period Certain = nothing after the death of the annuitant or until the stated time period; whichever comes last.

4.    Cash Refund = nothing after the full account has been paid out whether to the annuitant or a beneficiary.

 

On all of these options, nothing beyond the terms of the contract would be paid to the estate. Remember that an annuitant could live to be extremely old and still receive monthly income - far past the amount ever paid into the annuity. On the other hand, he or she could die far sooner than expected, leaving the beneficiaries with nothing from their annuity.

 

The type of annuitization or payout option chosen will determine the amount of money received each month by the annuitant and whether or not the beneficiary will have the option of receiving any remaining money. Some families will consider the beneficiary options with as much importance as the monthly amount for the annuitant. For this reason, it is very important that the agent fully cover the options with the annuitant.

 

Life Expectancy Payout Option (Stretch Annuities)

The Life Expectancy Payout Option is commonly called the Stretch Annuity. This is a relatively new concept considered an annuity legacy, offering contract holders more control over wealth transfer. There are both tax qualified and non-tax qualified stretch annuities.

Stretch annuities developed from Stretch IRAs. Individual Retirement Accounts were created to let individuals use the advantage of tax deferral to accumulate funds for retirement until they reached 70 . At that point the law required the account owners to begin withdrawing funds because the IRS wanted them to withdraw all of their money and pay all of the taxes before they died. If the person did not take distributions or if the amount distributed was not large enough, he or she faced a severe tax penalty equal to 50 percent of the amount by which the required minimum distribution amount exceeded the actual amount distributed.

 

These rules were fine for those who needed the income and wanted to take it. For those who did not need the income, however, there was no alternative. They were still forced to take the distributions and pay the applicable taxes. To make matters worse, the amount of the required minimum distributions increased annually. Not only must they pay taxes on increasing distributions that arent financially needed, but they also lose the benefits of future tax deferral and compounding interest on the amount distributed.

 

Fortunately for those that did not need the distributions, in January 2001 the rules governing IRA distributions were changed. The new rules establish much smaller required minimum distributions and allow individuals to maintain and maximize the benefits of their IRA by making it possible to stretch the distributions over the life expectancies of themselves and their beneficiaries. In other words, the 2001 rules allow a person to withdraw less, pay fewer taxes and ultimately pass greater wealth on to the designated heirs.

 

How does the stretching work?

 

Example: Ira owns an IRA. At age 70, Ira has $100,000 in the account and has no named beneficiary. Under the old rules, using the term certain method, Ira would be required to take a distribution of $6,530 each year from his IRA account. Each year more and more of his balance must be distributed. This means a loss of tax deferral and compounding of interest. Of course, it also means income for taxation.

 

Under the new rules Ira is only required to take a distribution of $3,649 from his IRA the first year, which is 44 percent less than previously required. Even though the amount of distribution required will still increase, it will be a lesser amount than previously required.

 

The ability to leave more funds in the IRA to benefit from tax deferral and compounding interest can have a major impact on future values of the IRA. For example, if the $100,000 balance were left untouched while earning 6 percent rate of return for 60 years, it would grow to $3,298,768.99. Of course, that is not likely to be the length of time an IRA is allowed to grow.

 

Under the old rules if was extremely difficult, if not impossible, for many IRA owners to stretch out their distributions over long periods of time. Under the new rules of 2001 it is now possible for individuals to stretch the distributions over the life expectancies of themselves and their spouse, or themselves and their beneficiaries.

 

The spouse is often the beneficiary of the IRA. Under the new rules, the age of the spouse determines which IRS table is used to determine the owners required minimum distribution amounts. If the spouse is less than 10 years younger (as well as with most beneficiaries) the owner uses the Uniform Lifetime Table and his or her payment amounts are based on his or her sole life expectancy. If the spouse or beneficiary is more than 10 years younger, however, the owner uses the Joint Life Expectancy Table to determine the applicable life expectancy factor, which results in smaller annual distributions.

 

Regardless of which table is used during the lifetime of the owner, each spouse beneficiary is entitled to complete a Spousal Rollover at the time of the owners death. The term Spousal Rollover means that if the IRA owner dies before his or her spouse beneficiary, the spouse can assume ownership of the IRA and begin new minimum distributions based on his or her own age. This Spousal Rollover option stretches the IRA income over a longer distribution period, and provides an income stream, increased financial independence and security for the spouse.

 

If neither the owner nor his or her spouse needs the distributions from the IRA, the owner could name their child as beneficiary. This may mean that the spouse would be required to waive community property interest and give his or her consent to the child being named as beneficiary. A relatively young beneficiary with a long life expectancy means a greater amount of money is left in the IRA to continue to benefit from future tax-deferred growth and compounding. This, therefore, stretches out the IRA distributions even more, with the exact time depending upon the age of the beneficiary and their expected lifetime.

 

While stretching out an IRA sounds like a great idea, it is not ideal for everyone. If the individual needed the IRA money to live on, there would be no point in stretching it out beyond their life.

 

Stretch annuities developed from stretch IRAs. A stretch annuity helps reduce the tax burden for beneficiaries as assets are passed through generations. If formatted correctly, it can be a simple and cost-efficient method of designating how and when beneficiaries receive assets, within legal limits.

 

For those investors who have amassed enough assets for retirement and wish to pass their estate on to beneficiaries, stretch annuities may offer investors everything they could want in an estate planning tool a flexible strategy that helps provide control over the assets, a potentially lessened tax impact for beneficiaries, and finally, the assurance that their legacies will continue to help provide income for generations, said Robert T. Cassato, President Of Manulife Wood Logan, the marketing and distribution arm of Manulife USAs Venture Annuity products.

 

For annuities that offer a stretch option, there are several potential advantages:

         The potential of increasing the account value by stretching tax deferral benefits over a longer period of time, even as withdrawals are taken out.

         Spreading their potential tax liability to the beneficiaries over their life expectancies.

         Creating greater flexibility in designing income options through systematic withdrawals; and

         Enabling the original contract holder to direct the investment and withdrawal of assets through generations.

 

Stretch annuities have the ability to be a multi-generational investment. Intermediaries also have the opportunity to stretch their advisory relationships through generations.

 

Income for Life Guarantees

In the past, once annuitization began, the owner had no access to principal, interest, or growth except through periodic payments. Some companies now offer a product that can be immediately annuitized while still allowing for additional withdrawals that may equal up to the entire account balance. These are typically only available in variable annuities.

 

Unlike traditional variable annuities that have an annuitization option that guarantees income for life, investors in these new products must earmark the number of years during which they will receive periodic payments. Once annuitization begins, the contract owner can cash out the remaining balance at any time. Other product designs allow partial withdrawals once the investor signs on.[1]

 

Tax Qualified or Non-Tax Qualified

 

Annuities may be either tax qualified or non-tax qualified. A tax-qualified annuity is one that meets specific parameters of the Internal Revenue Service.

 

Companies may use annuities for retirement plans. Variable annuities offer the employer a convenient method of establishing and contributing to employees retirement plans. Insurers offer corporations, sole proprietors, and partnerships a wide range of plans including IRAs, Keoghs, pension plans, profit-sharing programs, TSAs, SEP-IRAs, and 401(k) plans through annuities.

 

By eliminating the need to set up cash reserves for monthly redemption plans, variable annuities offer the employer and the employee the opportunity for enhanced returns. In a world of corporate takeovers and bankruptcies, employees like the idea that these plans offer guaranteed death benefits and other forms of security not always found with other retirement plans.

 

Individual Retirement Accounts (IRAs) are often set up through an annuity. Like retirement plans, an IRA is considered a tax qualified plan. IRAs are excellent retirement vehicles and offer choice in the type of plan utilized. There are both traditional and Roth IRAs. Not all individuals will qualify for a Roth IRA and it is important that a tax consultant be sought out to avoid errors.

 

Surrender Charges

 

Whether one considers a variable or a fixed-rate annuity, 100 percent of the money is invested for accumulation and distribution. There is usually no visible commission paid from the deposit (less than 2 percent of all insurers charge an upfront commission[2]). Of course, insurers do have fees. One of those fees is the surrender charge on early withdrawal. Annuities are considered to be a long-term investment so the surrender fees are one way of encouraging investors to leave their money in the vehicle. If the owner withdraws from their annuity (outside of the free 10 percent per year withdrawal option) there is usually a charge for doing so; this is called the surrender charge. The amount will vary, but usually it begins around eight or nine percent, decreasing down to zero percent in the final year of the surrender period. It might look something like this:

 

First Policy Year: 9%

Second Policy Year: 8%

Third Policy Year: 7%

Fourth Policy Year: 6%

Fifth Policy Year: 5%

Sixth Policy Year: 4%

Seventh Policy Year: 3%

Eighth Policy Year: 2%

Ninth Policy Year: 1%

Tenth Policy Year: Zero %

 

Annuities are sometimes referred to as a no-load product since commissions are not visibly paid from the deposit made. The commission that is paid by the insurer will vary, but generally runs from one to six percent. The exact amount will depend upon multiple factors, including the insurer, the product, and the interest rate paid to the owner. Since annuities typically do not remove a commission from the funds deposited, there is no advantage to the consumer for eliminating the agent. The consumer should seek out an agent that will be available over the years to help them if they need it, since the company will not give the policyowner any additional benefit for not using one.

 

California Insurance Code (10127.13) requires annuity contracts issued to persons 60 years old or older, termed senior citizens, containing a surrender charge period must either disclose the surrender period and all associated penalties in 12-point bold print on the cover sheet of the policy or disclose the location of the surrender penalty information in bold 12-point print on the cover page. A sticker affixed to the cover page or policy jacket may also be used.

 

Anytime a statement is issued to an annuity owner who is age 60 or older, the insurer must include not only the current accumulation values but also the current surrender penalties that would apply if the owner cashed in the annuity.

 

 

Other Charges and Fees

 

Annuities offer many benefits, but many times the benefits offered are not necessarily of value to the policy owner. Since the policy owner will pay for each benefit provided, it is important to understand the charges and also the benefit. The contract owner may find that the benefit being offered is of little value or importance to them. Some benefits, such as nursing home care, should be purchased separately - not included with their annuity.

 

Death Benefit

A common feature of variable annuities is the death benefit. This allows the contract owner to select a beneficiary (one or more) to receive the greater of: (1) all the money in the account, or (2) some guaranteed minimum, such as all purchase payments less any prior withdrawals.

 

Stepped-Up Death Benefit

Under a stepped-up death benefit, the guaranteed minimum death benefit may be based on a greater amount than purchase payments minus withdrawals. For example, the guaranteed minimum might be the account value as of a specified date, which may be greater than purchase payments minimum withdrawals if the underlying investment options have performed well. The purpose of a stepped-up death benefit is to lock in the investment performance preventing a later decline in the account value, which would erode the amount that would otherwise be left to beneficiaries. There is a charge for the stepped-up death benefit, which will lessen the account value.

 

The Guaranteed Minimum Income Benefit

Another feature that comes with a charge is the guaranteed minimum income benefit. This guarantees a particular minimum level of annuity payments even if there is not enough money in the account, perhaps due to investment losses, to support that level of payments.

 

Long-Term Care Benefits

Life insurance policies and annuity contracts may have a clause or provision that allows funds to be used, without surrender penalties, for long-term care nursing home charges. There are usually specific requirements that must be met. For example, the policy may not pay until the insured has been in the nursing home for a minimum of six months.

 

Deferred annuities and immediate annuities may be purchased that are specifically for the nursing home. A long-term care fund can be set up that will directly pay for long-term care services or for long-term care insurance. This allows the fund to grow, through interest earnings, while still earmarking it specifically for this type of service.

 

The deferred annuity has two funds: a long-term care fund that pays directly for services or insurance, and a regular cash fund that grows at a guaranteed rate of three percent. To be eligible for this type of annuity, one usually must be under the age of 85 and answer a few questions about current health conditions. There are some conditions that will prevent issue of this type of annuity, such as dementia or Parkinsons disease. If the individual is eligible, the long-term care coverage can start after the seven-day waiting period.[3]

 

The monthly long-term care benefit payout depends on the deferred annuity value. Obviously the more money put into the annuity the more it will pay out. Most of these annuities are designed to pay benefits for 36 months. Additional coverage may be available, however.

 

Medicares website lists the following opportunities:

 

Deferred Annuity Opportunities:

Deferred Annuity Requirements/Limits:

It may be easier to qualify for a deferred annuity rather than a long-term care insurance policy.

Deferred annuities are non-tax qualified long-term care policies and may subject the insured to certain tax liabilities. The IRS can further advise individuals.

This is a separate fund and the insured can use the money right away for long-term care costs or to buy a long-term care insurance policy.

If the annuity does not include inflation protection, there might not be enough to fully pay for long-term care needs. This is also true if not enough is deposited.

The annuity might cover the cost of prescription drugs.

The benefit amounts might not be enough to pay for the long-term care needs fully.

If the insured doesnt use the entire long-term care annuity, their beneficiaries will be able to receive the balance.

Usually provides coverage for up to 36 months, although additional coverage may be available.

 

An immediate annuity is for people who cant get insurance for the nursing home due to existing health conditions. Even if an individual is already receiving long-term care they may be able to obtain an annuity.

 

This type of annuity does typically utilize medical underwriting. That means that a few medical questions must be answered. It is important to fully answer all medical questions since incomplete or incorrect answers could void the policy. To qualify, after medical underwriting is completed, a single premium payment is converted to a guaranteed monthly income. This monthly income will continue for the duration of the insureds life.

 

Medicares website lists the following opportunities:

Immediate Annuity Opportunities:

Immediate Annuity Requirements/Limits

The insured can use the money to pay for long-term care needs.

If the insured doesnt know the type or cost of the long-term care they will need, the income received might not be sufficient.

If the insured is already getting long-term care, he or she can still receive this type of annuity.

If the annuity doesnt include inflation protection, it might not fully cover the long-term care costs over time.

The insured might be able to leave any remaining funds to beneficiaries.

The insured may or may not have to pay taxes on this annuity. For more information, the insured should check with the IRS or their tax advisor.

 

Mortality and Expense Risk Charge

Different types of annuities will have different types of charges. This charge is equal to a certain percentage of your account value, typically in the range of 1.25% per year. This charge compensates the insurance company for insurance risks it assumes under the annuity contract. Profit from the mortality and expense risk charge is sometimes used to pay the insurers costs of selling the annuity, such as a commission paid to the agent. The insured may not realize these costs since they represent a reduction in account growth.

 

Administrative Fees

The insurer may deduct charges to cover record keeping and other administrative expenses. This may be charged as a flat account maintenance fee, such as $25 or $35 per year, or as a percentage of the account value, such as 0.15% per year.

 

Underlying Fund Expenses

Depending upon the annuity and how it is invested, there may be expenses for mutual funds that are the underlying investment option for variable annuities (if that is the case). There may be other fees that are specific to a particular type of annuity.

 

Market Value Adjustments

Some insurers use a provision called market value adjustments which adjusts the accumulated fund balance, not the yield, upward or downward. The adjustment is in the opposite direction of the interest rate movements. If the current rate is higher for new contributions than for other money, the value of the investors account will decrease. A decrease in the current rate results in an increase in fund value. As a result, accumulated money can constantly change in value, even though the annuity is fixed-rate.

 

Charges, such as initial sales loads, or fees for transferring part of an account from one investment option to another may also apply. All charges should be fully explained to the insured. Variable annuities will have a prospectus that should also give a fee description.

 

Fixed Annuity Provisions

 

The idea of a fixed annuity is basic: an individual gives a sum of money to an insurance company in exchange for the promise of a fixed monthly amount of income for either life or a specified time period (depending on the option chosen at annuitization). As we have previously stated, every annuity has two basic properties:

         It pays either immediately or is deferred to some future date.

         It is either a fixed or variable vehicle meaning the interest rate paid is either fixed or variable.

 

A fixed annuity has no sub-accounts. Only a variable annuity has these due to the type of investing involved.

 

The fixed annuity, for a sum of money paid to an insurer, promises to pay a fixed monthly amount for life or for a fixed period of time. This is the concept of annuitization (although many people never do so). Essentially, this means that a person is converting a lump sum into an income stream. Whether the contract holder chooses a lifetime income or a period-certain income, the payment does not change, not even to account for inflation (something some professionals feel is a disadvantage).

 

If a fixed period is chosen (period-certain income), the annuity continues to pay until that period is reached, whether to the original investor or to his or her beneficiary. If a lifetime payout option is chosen the fixed annuity will pay only for the life of the insured. Nothing will be paid to any beneficiary, even if there is still money left in the account when the insured dies.

 

Fixed annuities, prior to annuitization, do have some withdrawal features. Although each annuity may differ, most allow a ten percent principal withdrawal annually. Some allow a ten percent account withdrawal annually, which would include both principal and interest. Many contain hardship clauses, also called crisis waivers that allow the owner to withdraw the investment with no surrender charges. Since annuities can differ in their terms, it is important to fully read the policy to see which ones allow this. As previously stated, be aware that all benefits cost something. What they cost may not be obvious but there is always a fee for any benefit received.

 

Annuitization can work well for the individual that lives a long time. He or she may withdraw (on a lifetime option) far more than ever paid in. It doesnt work for everyone. If the insured feels it is not likely they will live to a ripe old age, it may be better not to annuitize at all, waiting until the surrender period passes, then drawing off as needed.

 

Statistically, many people with individual annuities do not annuitize, choosing instead to leave their account standing for their beneficiaries. For those with annuities connected to their pensions, taking their income in one lump sum or through multiple payments has only recently been a decision they had to make. Previously, the decision was made for them by their account executives. The workers were set up on a monthly basis with checks arriving at regular intervals.

 

In the 1990s employers began offering retiring workers the choice between lump sums and monthly payments. According to the Department of Labor Statistics, approximately one in four employers began offering lump sum options. That percentage is growing.[4] Lump sums are cheaper to pay out for employers, so there is actually an incentive for them to promote lump sum payments over installment payments. Experts report that about 90 percent of the workers do choose lump sum payments.

 

Certified Financial Planners are questioning the wisdom of lump sum payments from retirement annuities. Part of the problem is that the lifetime value of a lump sum payout typically is worth less than the lifetime value of an annuity, sometimes by as much as 50 percent less (assuming the worker lives to his or her life expectancy). If the lump sum is taken, experts advise the workers to roll it over into some type of account that will perform long-term.

 

When an individual looks at the vast difference between the amounts they would receive each month and the amount they would receive in a lump sum it is easy to understand why the lump sum would look attractive. Even if their employer provides their expected lifetime return on a monthly payout basis, people often believe they can better invest their money.

 

Even when a worker has all the numbers, some factors may not be considered. For example:

 

         Workers with expected shorter than normal life spans due to health conditions or life styles may find the lump sum is the better choice. Since they are less likely to live to full life expectancy (thus collect the full amount) they may be able to better invest the lump sum amount, taking into consideration beneficiary designations.

         Workers with full or longer-than-average life expectancies may prefer annuities in order to lessen the risk of running out of money. It is these individuals who may benefit the greatest from a lifetime annuity option.

         For those who chose to invest the lump sum payout themselves (rather than allow the insurer to handle their money) it is important that all factors be considered. In theory, the individual could end up earning more than if they had taken the annuity, but they could also end up losing money or suffer anemic returns due to a poor investing climate. It is also possible that the individual turns out to be a poor decision maker when it comes to money.

         A lump sum does offer flexibility, which would not exist with an annuity. An annuity would not allow the owner to take out extra money for special needs, whereas a lump sum invested elsewhere may allow this. Of course, this also allows the individual to take out extra money as often as he or she desires, assuming the lump sum has no restrictions placed on it. It is possible that the individual could spend the entire lump sum long before their life runs out.

         While annuities, under the life option, will not forward any remaining money on to beneficiaries, under a lump sum the surviving spouse and family may receive it. Of course, this would depend upon where the lump sum was invested, but it is likely to be invested in some way that did recognize beneficiaries.

         If the lump sum is rolled over into an IRA, it could be stretched out to the required minimum payments so that as much would be received as would have been under the annuity.

         Most annuity payments arent adjusted for inflation. That means that the monthly income would buy increasingly less as time went by.

         The decision of lump sum versus monthly income may depend, at least in part, on other financial resources that exist. If the individual already has substantial resources that will produce income in retirement, such as a 401(k) or IRAs, taking the annuity as a life income may free up the other assets. The worker could live on the annuity and use the other assets as beneficiary designated money, for example.

 

It is important to realize that a fixed annuity that is annuitized on a life option carries no guaranteed death benefit. Thats because a life option does not go beyond the insured (annuitant). A fixed annuity was not designed for the beneficiary; it was designed for the insured with a lifetime income the goal.

 

Flexible Annuitization Options

There are some insurers offering a flexible annuitization. These products can be immediately annuitized while still allowing for additional withdrawals that may equal up to the entire account balance.

 

Unlike traditional variable annuities that have an annuitization option for life income, investors in these flexible products must earmark the number of years during which they will receive periodic payments. Once annuitization begins, the contract owner can cash out the remaining balance at any time. Other product designs allow partial withdrawals once the investor signs on.

 

Non-Spouse Beneficiaries

A new IRS ruling allows non-spouse beneficiaries of employer-sponsored retirement plans to defer distributions. This breakthrough ruling by the IRS came about due to particular events that presented the problem that existed. The issue related to retirement plan distributions after the owners death. There is no problem if the beneficiary of a retirement plan is a spouse, because a surviving spouse can roll the account balance over to his or her own IRA. The problem existed, however, if there is not a living spouse. As stated by Seymour Goldberg, a senior partner with Goldberg & Goldberg, a law firm in Melville, NY: A non-spouse beneficiary may have to take out the plan assets and pay all the deferred income tax within a reasonable period of time. Usually thats within one year. The non-spousal beneficiaries of employer-sponsored plans do not have the option of rolling the account balance over into their own IRA.

 

Not all non-spouse beneficiaries had a problem since some retirement plans have a provision for stretching the distributions over such a beneficiarys life expectancy (stretch annuities), extending the tax deferral. Unfortunately not all company plans offer this. Some of the largest U.S. companies and major fund custodians dictate that payouts to non-spouses be sooner than later. Small plans especially may not be able to provide such benefits, since the administrative burden would be great for them. Therefore, beneficiaries that are not spouses may be faced with the IRS requirement that all the money be withdrawn and have tax paid on it right away.

 

In the case of Goldbergs client, he discussed the problem with the IRS. They understood the argument for fairness and came up with a procedure for continuing tax deferral. The solution, based on an obscure IRC provision about nontransferable annuities, was cited in a private letter ruling as requested by the deceaseds son.

 

According to the tax code, a retirement plan can buy and distribute a nontransferable annuity without triggering a tax bill, explains Steve Lockwood, president of Lockwood Pension Services in New York. A nontransferable annuity is one that cant be sold, given away, assigned, or pledged as collateral for a loan or other obligation.[5]

 

Finding the right annuity is not an easy task. The annuity must be nontransferable and offer certain distribution options. It must effectively re-create an inherited IRA. The annuity must pay out at least the minimum distribution that the beneficiary is required to take each year. It is desirable to have it allow greater than minimum distribution if the beneficiary so desires. In the case of Lockwoods client, they decided to have an annuity product designed specifically for them. He found an insurer willing to do so, based on a private letter ruling from the IRS.

 

The Keogh plan in question purchased the custom annuity, and then the plan trustee transferred the qualified distributable annuity (QDA) to the trust named as the plans beneficiary. The transfer was tax-free under the ruling. The deceaseds son, as a non-spouse, may still benefit in the way that a spouse would have. He will receive annuity payments that conform to the IRS minimum distribution table.

 

Technically, an IRS private letter ruling applies only to the taxpayer making the request. However, such rulings show the thinking of the IRS, so they have a broader impact. Others have already used the ruling to benefit others. Gary Friedenberg, an estate-planning attorney in New York, used the ruling to get some tax relief for one of his clients.

 

Steve Lockwood says the type of annuity that was customized for his client is becoming available. They no longer have to be customized. It may be necessary to add a rider to the contract, but they are available. Non-spouse beneficiaries are starting to successfully use these annuities without requesting their own private letter rulings. The ruling obtained was clear, so people are doing it says Lockwood. Some cooperation between the retirement plan must exist, since they must be authorized and willing to purchase the annuity.

 

It is possible that we will see other situations come up where QDAs are valuable. For example, an account in an employer-sponsored plan may be divided among two or more beneficiaries (non-spousal). Separate shares could be created up to September 30th of the year after death, according to Lockwood. Each beneficiary would have to decide whether or not to purchase an annuity.

 

If Congress acts to treat non-spouse beneficiaries the same as a spouse, this whole matter may become moot. In the meantime, it is likely that financial planners will see an increasing need for qualified distributable annuities (QDA).

 

Fixed Annuities

 

Fixed-rate annuities are less complex than their variable counterparts. The features that may be seen in fixed-rate annuities include:

 

1.    A guaranteed amount at the end of a specified time period.

2.    Free bail-out provisions.

3.    The ability to add new contracts.

4.    A promise of income in the future.

 

There are varieties of fixed-rate annuities. One such variety is the CD-Like annuity, which may be known simply as a CD annuity. It is a short-term version of the fixed-rate annuity designed to compete with Certificates of Deposits.

 

Fixed-rate annuities are so named because the rate of interest earned is guaranteed. At the end of a specified period of time the investor knows for certain that a specified amount of money will exist. The point of this guarantee is to provide a guaranteed income when the investor chooses to annuitize and begin receiving monthly income.

 

When a person invests in a fixed annuity, the specific annuity chosen will set a guaranteed rate of interest growth that will accumulate until the contract owner chooses to begin receiving income. The length of time that the rate is fixed for will depend upon the annuity chosen. Note that the investor chooses when this event takes place. It is not necessary to ever begin receiving income, but that is the intent of the financial vehicle. The longer the growth period of the annuity, the higher the interest rate available to the investor. In other words, if the investor chooses an annuity designed to grow for a ten-year period the rate of interest earned is likely to be higher than one designed to grow for only three years. The rate that is locked into the annuity is usually guaranteed even if outside interest rates go up or down during that time period. It is common for fixed annuity interest rates to be very similar to what is currently being offered for Certificates of Deposit.

 

Since fixed rate annuities may fix the rate at the time of issue, the question that arises is not surprising: What happens if interest rates rise? It is possible that the issued annuity will not pay as high as other vehicles (even other annuities) if interest rates rise following issuance. The rates are guaranteed to remain as issued at the time of application. If interest rates tumble down, then the investor will be earning more than could be obtained elsewhere, but if rates rise it is likely that he or she will be earning less than could be obtained elsewhere. Some annuities only make guarantees for a specified period, such as a year. At the end of the year a new rate is set based on the indicators stated in the annuity contract. These types of annuities are more likely to be current with interest trends, whether up or down, from the issue date of the annuity.

 

All fixed-rate annuities have a guaranteed minimum rate of interest. At no time will the interest rate ever go below that stated figure. Current interest rates may be higher, but never lower. What is the difference between a guaranteed minimum rate and a current rate? The minimum rate is the lowest it will ever go, no matter what is happening elsewhere in interest rate trends. The current interest rate is the rate the company has chosen to pay, which is typically higher than the minimum guaranteed rate. Current rates are higher because the insurer has chosen to pay a higher rate, not because they are required to.

 

In past years, the current yield on annuities was nearly always higher than guaranteed rates, but recently this is not nearly as likely to be the case. Interest rates have reached historic lows. Many guaranteed rates on annuities ended up being higher than was available anywhere else, except in high-risk investments.

 

Bail-Out Provisions

Under the free bail-out provision, a contract owner can liquidate the annuity without fees or penalties if the interest renewal rate is lower than the original rate by a contractually specified percentage, usually one percent.

 

Bail-out rates are closely tied to the guaranteed interest rate provision of a fixed-rate annuity. Bail-out rates are only as good as the guarantees in them and not all are excellent.

 

The bail-out provision should be straightforward: after the guaranteed interest rate period is over, if the renewal rate is ever lower than 1 percent less than previously offered, the owner can liquidate part or all of the annuity principal and interest, without insurer fees or penalties. It is possible that early withdrawal penalties would apply from IRS if the money were not rolled over into another like investment vehicle.

 

If the contract owner moves their money even though the annuity did perform as promised, then any fees or penalties would apply. The bail-out provision only waives such fees and penalties if the annuity fails to perform as promised.

 

Adding Money

A fixed annuity is a contract between two parties: the insurer and the contract owner. The insurer makes specific promises regarding a rate of return. If the contract owner wishes to add additional money, it will be necessary to purchase additional annuities, since the guarantees were only made on the original deposit. Additional annuities would be purchased at the current guaranteed rates. Even if the owner purchases from the same company as the original annuity, interest rate guarantees may be different. Each annuity will be a separate contract.

 

Guaranteed Future Income

Fixed rate annuities make future guarantees for the contract owner. One of the reasons so many Americans use fixed rate annuities is to secure a future income during retirement. The exact amount that will be guaranteed depends upon several factors, including how much is deposited, the length of time involved in interest earnings (obviously the more time there is to earn interest, the better), and how the annuity is annuitized. Lifetime income will give a lower monthly amount than some other options that provide income for a limited time period.

 

The annuity contract will tell the owner exactly what may be expected in income at a later date.

 

The CD Annuity

In the 1980s insurers put out a product designed to compete with Certificate of Deposits. This new type of fixed-rate annuities provided a comfort level to those consumers who wanted a shorter period of time binding their investment. Typically, a CD annuity has just a one-year contract.

 

It is important to realize that the one-year period applies only to the insurer issuing the contract. The fact that they will not impose penalties does not mean that the IRS will not if withdrawals are taken prior to age 59 , unless the annuitant dies or becomes disabled. A 10 percent IRS penalty will occur if the contract owner does not use a 1035 exchange to move the money to another like investment. The tax event will only be triggered on the amount considered to be interest.

 

Low Interest Rates Affect Fixed Annuity Sales

When interest rates hit historic lows, fixed-rate annuity sales tend to drop. In 1996 alone sales dropped to $39 billion, which represented a 21 percent drop from 1995.[6] In 1985, fixed annuities accounted for 82 percent of all annuities sold, but in 1996 they accounted for only 35 percent of those sold.

 

It is not surprising that Americans who favor Certificates of Deposit also seem to favor fixed-rate annuities. Many reposition CD funds to annuities. In fact, it is often bank personnel that move the money from CDs to annuities, earning the bank a commission in the process.

 

Money market investors also seem to favor fixed-rate annuities. Historically, fixed annuities have proven to be as safe as money market accounts, while providing a higher rate of interest. These investments are safe because their reserve requirements exceed 100 percent of all investors contributions. Annuities are not as liquid as money market funds, but there is accessible cash (10 percent of cash values in most cases). If the annuity is a flexible premium contract, the investor may make additional deposits each year, which also seems to attract the money market investors.

 

Probate Avoidance

Another feature that seems to attract investors to fixed rate annuities is the ability to bypass probate. While the asset must still be mentioned in probate, it is not delayed by it as other assets may be. Annuities bypass the process of probate as long as a beneficiary other than the estate is named in the contract.

 

Annuities are often used to fund the costs connected to probate. Since funds transfer immediately upon death, an annuity may be set up with taxation in mind. The funds may be used to pay income taxes, debts, or make gifts to specified entities and people.

 

Annuities offer other tax flexibility. Upon the death of the annuitant, income taxes are normally due. With an annuity, taxes can be delayed for up to five years after the death of the second spouse. If there is no spouse, income taxes can be delayed for five years or the investment can be annuitized for immediate distribution and some tax relief.

 

Variable Annuities

 

Variable annuities are more complicated than fixed annuities. A variable annuity represents an investment company that makes investments on behalf of people and entities that share common financial goals. They offer investors the opportunity for wealth accumulation through the use of tax-deferral, professional asset management, asset allocation, diversification, and risk management. Many feel the variable annuity is particularly well suited to assist investors over the long term. It combines the advantages of tax-deferred wealth accumulation with the flexibility of mutual fund investing. Both earnings and capital gains are tax-deferred. Because they are tax-deferred, the investments grow faster than they would if taxes had to be paid each year on the earnings. These tax-deferred earnings include the contributions made by the contract owner, the interest that it earns, and the capital gains that result. They will continue to be tax deferred until either the money is withdrawn or annuitization is initiated, which also means withdrawals begin.

 

One of the characteristics that investors appreciate about variable annuities is that they can control their contract options. They dictate the amount and regularity of their contributions, how their contributions are invested, and how and when the money is distributed. Like the fixed-rate annuities, variable annuities may also be used to guarantee a lifetime income, once annuitized.

 

There are three elements to variable annuities: investment, accumulation, and disbursement. This, of course, is true of many types of investments.

 

In the investment phase, premiums are paid either as a single one-time premium, periodically, or sporadically. Generally, it is not subject to an initial sales charge. All proceeds will be invested in the sub-account portfolios that have been selected of stocks, bonds, or money markets. During accumulation, earnings compound on a tax-deferred basis, which prevents loss to taxation.

 

When the investor is ready to receive income, he or she may take out partial withdrawals, usually ten percent of the account value, without fees or penalties. He or she may also annuitize the variable annuity without paying the insurer fees or penalties. If the investor were under age 59 , there would be penalties levied by the IRS. Therefore, investors usually do not withdraw prior to that age. After age 59 , the investor may take a lump sum or partial withdrawal without IRS penalty.

 

Tax-deferred earnings are considered a major advantage by virtually all in the financial fields. Even those that prefer other investment vehicles agree that tax-deferral is a major advantage of the annuity both fixed and variable. Combining tax-deferral with the ability to reallocate assets without incurring a taxable event makes the variable annuity a competitive investment. Professional money management is also often quoted as a major reason that variable annuities make sense.

 

Sub-accounts now cover all major asset classes. Competition dictates that managers balance risk and return. The abundance of sub-accounts offers investors sufficient options to meet virtually any investment desire. Most variable annuities offer from 10 to 20 sub-account options. Sub-account exchanges do not create taxable events and have no sales and transfer charges, although some companies set limits on the number of annual exchanges. If more than the allowed amount occurs a transfer fee is charged.

 

Most variable annuities, like fixed-rate annuities, do not have front-load sales charges. The full amount deposited is credited. However, a contingent deferred sales charge (CDSC) may be assessed for early surrender. Withdrawal penalties are usually based on the purchase payments only, from the time of purchase.

 

Many people like variable annuities because of their liquidity. Many allow systematic withdrawals without penalty after the first year, subject to certain percentage requirements. There is no statutory age requiring withdrawals, so many annuities never experience withdrawals at all. Even if partial withdrawals are taken, many are never annuitized.

 

The annuity owner has the option of listing a beneficiary on the policy. If a person is listed (not the estate), account balances can transfer to the heirs outside of probate. This will depend upon whether or not it was annuitized and if it was annuitized, the option selected.

 

The contract owner also selects the annuitant and, if desired, the contingent owner. He or she may change those selected during the accumulation phase. The owner decides if and when distributions begin, so the accumulation phase could continue indefinitely. Since the owner can decide distributions (and in what combinations), he or she can determine their own tax consequences. When the owner dies, the annuity passes directly to the designated beneficiary, if one is named, without going through probate.

 

Death Benefit Guarantees

Insurance companies issue annuities and are considered insurance policies. If the annuity has not been annuitized at the time of the contract owners death, as previously stated, proceeds are paid to the beneficiary listed. The amount paid is always at least 100% of the total of the funds that were invested less prior withdrawals and prior applicable surrender charges. When the contract owner dies, all future surrender penalties are waived, regardless of the length of ownership. California Insurance Code 10168.4 specifically requires that surrender benefits may not be less that the present value as of the surrender date, less any previous withdrawals. It further states that the surrender value must be calculated on the basis of an interest rate that is not more than one percent higher than the interest rate specified in the contract for accumulating the net considerations to determine the maturity value. It may be decreased by the amount of any indebtedness to the company (including interest), and increased by any existing amounts that should have been credited. The surrender benefit may never be less than the minimum nonforfeiture amount at that time. The death benefit under such contracts must be at least equal to the cash surrender benefit.

 

There are several distribution-at-death options available to owners of nonqualified annuity contracts. They do require ownership, annuitant, and beneficiary designations by the annuity owner:

 

1.    Lump sum distribution, where the entire annuity value is withdrawn in one payment.

2.    Lifetime income, where the contract is annuitized so that a lifetime income is received, regardless of how long one lives. The amount received will depend upon several factors considered by the insurer, including the amount deposited. Once the annuitant dies, no further distribution would be made.

3.    Lifetime with period certain, where income is received for the duration of the annuitants life, but absolutely for a specified time period if the annuitant dies prematurely. While the time period specified can vary, it is often for ten or twenty years. If the annuitant dies prior to that period certain, the beneficiary listed will receive the remainder of that specified time period. The time period begins with the first annuitized payment received by the annuitant.

4.    Systematic withdrawals where the owner determines his or her distribution needs and draws out that amount systematically until the amount deposited is gone. The contract is never annuitized.

5.    No withdrawals where the contract owner lets the money deposited remain with the insurer throughout his or her lifetime. It grows tax deferred, earning interest. At the owners death the proceeds go to the named beneficiary.

 

Annuities are backed by all the guarantees made on other insurance products. Annuities guarantee that the beneficiary will receive either the original principal amount invested less withdrawals, the current market value of the account, or the guaranteed stepped-up value, whichever is greater, at the contract owners death.

 

Fixed annuities are backed by the insurer guarantees. The insurance company must meet specified reserve requirements established by the individual states. The insurance company may invest in specified types of investments in order to preserve the integrity for the reserve accounts. The states all monitor the annuity portfolios.

 

Variable annuities are backed by the insurers, but have an additional safety feature: the securities for the underlying portfolios (sub-accounts) where the annuitant invests are held by a trustee.

 

Equity or Debt

All investments fall into one of two categories: equity or debt. This is true of virtually every investment past and present. Debt instruments are those where you have loaned someone else the use of your money. This would include IOUs of an individual, company or government. Debt instruments, therefore, include trust deeds, notes, Certificates of Deposit, municipal bonds and U.S. government bonds.

 

All equity instruments concern partial or complete ownership of an asset (such as owning equity in ones home). Equity instruments include stocks, real estate, business interests, oil, precious metals and certain types of variable annuity portfolios, such as aggressive growth, growth, growth and income, and international stocks.

 

Purchasing growth stocks in a variable annuity portfolio is considered an excellent method for wealth accumulation as well as tax deferral. While the value of a stock investment might grow substantially, taxes will not be due on the gains until the stock is sold.

 

Annuity Earnings

Every investor expects to receive interest earnings on their investment. That is, after all, the point of investing. Most investors are really savers, putting money aside to earn interest for use at some later date. What is the difference between an investor and a saver. Investors are much more willing to assume risk. Savers want security. Savers expect to leave their savings unspent for a prolonged period of time. Whereas investors may feel that an annuity does not have the growth potential they desire, a saver will appreciate the guaranteed interest and potential for lifetime income.

 

Unfortunately, savers may not realize the loss that happens due to inflation when growth is not adequate to keep pace. While annuities have an appropriate place as part of a total investment strategy, it is not likely to be sufficient as the investment strategy. It is always better to save a little than nothing at all, so it is also better to save only in annuities than no place at all. Most financial planners use annuities, but they also use other types of investments so that the more risky ones are balanced by the more conservative vehicles. Annuities would be considered among the more conservative.

 

An investors real return is the total return adjusted for inflation. Inflation is measured by the Consumer Price Index, usually referred to as CPI. After tax and inflation returns on risk-free investments can deliver a negative return for savers. Therefore, tax deferred conservative vehicles, like annuities, do help to partially offset the effects of inflation.

 

It is important to understand the different types of returns so that take place:

 

Total Return: Annual return on an investment including gains (losses), dividends, and interest.

 

Negative Net Return: If the net return on an investment is less than the inflation rate, the saver has actually lost purchasing power.

 

Positive Net Return: If the net return on an investment is more than the inflation rate, the saver has gained purchasing power, which is of course the intent.

 

Americans often focus primarily on market risk, assuming that to be their largest risk. In fact, for long-term investments the larger risk is loss of purchasing power. That is why annuitization is not necessarily a wise move since it sets the payouts that will be received. The typical investor and saver want to establish a secure future. After financing home ownership and establishing college funds, retirement is typically the goal. Annuities can work well as part of achieving that goal, but only if the investor understands how inflation can cause an erosion of their assets.

 

Dollar-Cost Averaging (DCA)

Dollar-cost averaging is the technique of investing a fixed sum at regular intervals regardless of stock or bond market movements.[7] This reduces average share costs to the investor. In lower price periods, it will allow purchase or more shares than will be possible in times of higher prices. As a result, investment risk is spread out. This is how many portfolios are developed. The method dictates that the investor purchase fixed dollar amounts of sub-accounts at regular intervals without regard to price.

 

It is important to realize that dollar-cost averaging reduces risk, but it does not guarantee profits. To arrive at the average purchase price, the investor would chart the amount invested and the amount of stocks or mutual funds purchased over a set period of time. The average amount of that time interval would be the average unit price. Bruce Wells, in his book All About Variable Annuities, uses this illustration:

 

Assume a $2,000 a month invested for six months. The total investment is $12,000.

Price: Units Purchased:

$20 100

18 111

16 125

14 143

16 125

18 111

$102 715

 

Total cost of $12,000/715 = $16.78 per Unit average cost. Average purchase price $102/6 = $17 per Unit price. (Total prices/Total Purchases.)

 

Equity Indexed Annuities (EIA)

 

Equity-indexed annuities have been available in Europe for a number of years but the States have only had them available since the 1990s. Equity indexed annuities are simply fixed annuities that employ a formula linked to an independent index to arrive at a credited interest rate.[8] In the traditional fixed-rate annuity pricing, credited rate represents one variable but this has been split into four or more variables in equity indexed pricing. Interest rate has become a function of (1) participation rate, (2) spread, (3) cap, and finally (4) index method. So, essentially, indexed annuities are just fixed annuities with a special way of determining the credited rate.

 

Any annuity must balance all related elements: interest rates, commissions, renewals, surrender charges, liquidity, and account values paid at death. An equity-indexed annuity provides the investor with participation in the stock market without any downside market risk. Therefore, there is no losing or negative period.

 

Stock market participation in the United States is usually linked to the S&P 500, so one would think that an equity instrument would be classified as a variable annuity, but thats not the case. Most equity-indexed annuities are fixed-rate contracts.

 

In a fixed-rate annuity the insurer guarantees a rate of return for a specified time period, guarantees a minimum rate of return, and guarantees the investors principal at all time. The insurer, with these guarantees, bears all investment risk rather than the investor.

 

In a variable annuity, the investor assumes all investment risk; money is invested in one or more sub-accounts; and investment choices range from very conservative to high-risk aggressive. The investor bears all market reward in variable annuities (unless a fixed-rate sub-account is selected).

 

Equity-indexed annuities have all of the features of most fixed rate annuities except the interest credited to the investors account is linked to a well-known market index, usually the S&P 500 [9] in the case of American products. An equity-indexed annuity, unlike a variable annuity, cannot decrease in value if it is held for the contracted period of time. There is a fixed minimum guarantee like the fixed-rate annuity and the value of the investors account can only increase due to stock market appreciation. It will never decline.

 

While this might initially sound fairly simple, EIAs are considered a rather complex investment product. An agent who does not fully understand all issues should avoid recommending them.

 

Terminology for Equity-Indexed Annuities

 

Term: the length of time the insurers penalty lasts or when the investor has the option to renew the contract. The most common term is between three and seven years. However, there are some for as little as one year. They may also last as long as ten years.

 

Participation Rate: This is one of the most distinguishing features of the EIA. It may also be called the index rate. It refers to the percentage increase in the S&P 500 that the investment will grow by. While the actual amount may vary, as an example it may read 80 percent of the S&P 500s increase for any given calendar year. Note that this would mean the investor would receive less than what the S&P actual increase is for the contract period stated. This is understandable given the guarantees that the EIA carry.

 

Index Credit Period: The credited amounts received by the Equity-Indexed Annuities happen at specific points in time. The Index Credit Period is probably the biggest difference between fixed-rate and Equity-Indexed annuities. The amount (credit) is based on the increase to the index that takes place between defined points in time. The defined time period might also be called the current crediting rate.

 

Administrative Fee: This fee may also be known as the annual fee, spread yield, or expense load. It is a reduction from the increase in the S&P 500. The reduction is a fixed rate that is subtracted by the insurance company. The exact percentage amount will be stated in the contract.

 

There is typically an administrative fee on contracts that have a 100 percent participation rate. Therefore, if the participation rate is less than 100 percent, there may not be any administrative fee. When there is an administrative fee, it is usually between 1 percent and 2.25 percent.

 

Cap Rate: The cap rate is the annual maximum percentage increase allowed. Both the cap rate and the participation rate are methods used by the insurer to offset the costs of offering fixed minimum guarantees (making sure the investor does not have a losing period even when the S&P 500 does). Not all EIAs have a cap rate.

 

There is a trade-off. In order to reduce the cost of the product, the insurer must make some compromises. This means that the higher the participation rate, the lower the cap (the maximum that the account will grow during the period, regardless of how well the stock actually performs). For example, a compromise may state:

90 percent participate rate in the S&P 500 with a 13 percent cap.

 

Floor: This refers to the minimum amount that will be credited to the investor, regardless of the indexs performance. The floor is often three percent per year, but may be as low as zero during periods of low interest rates.

 

Index benefit: how much an investor actually earns.

 

Liquidity: The ability to get back most or all of the investment at any time.

 

Reference or Contract Value: This is what the investor will look for. The investor is always entitled to the greater of the current account value, less any surrender charges that remain, or the investors principal. While contracts do vary, it will often state the contract value as equaling 90 percent of all dollars invested plus 3 percent compounded annually. The figure may be higher or lower than 90 percent, however. This provides the investor with an additional guarantee: no matter how much the stock market may go down or remain flat, the value of the contract will increase if the investment is held for the agreed-upon period of time.

 

Index Credit Periods and Methods

The point of Equity-Indexed Annuities is to provide stock market participation with downside protection. However, there may be different index credit periods and methods from product to product. How the EIA is structured impacts the amount and timing of the investors gains. Gains will be limited through its participation rate, cap rate, the administrative fee, liquidity, or how the index credit period is calculated.

 

It is very difficult to compare Equity-Indexed Annuities. There can be differences among products even within the same company. The differences in the index credit periods and methods fall into one of three broad categories, which do help in comparisons, however. Those categories are annual reset, point-to-point, and annual high-water mark with look-back.

 

Annual Reset

The annual reset is used to determine annually how much is to be credited to the equity-indexed annuity investors account. Appreciation in the S&P 500 is based on the anniversary date of when the investment began. Therefore, the annual reset is calculated by taking the ending value of the index 365 days after the investment began and subtracting from it the value of the index at the end of the first day (anniversary date). The difference between these two points is how much the investors account is credited, less any administrative fees, multiplied by the participation rate, and subject to any upward cap rate.

 

Volatility will not affect this. The annual reset method (also known as the annual ratchet method) is concerned only with two index figures, one at the beginning of the year and one at the very end of the year. Any compounding is done on an annual basis.

 

The annual reset method allows investors to profit even after a bad year. In fact, investors who are in contracts using this method of calculating gains may even hope for a negative year since the next years starting point would be even lower making it more likely for there to be a recovery.

 

Financial professionals who describe the EIAs often use a chart that shows the performance of the S&P 500 over a period of time divided into three sections or zones: the beginning of the investment is shown in the first slot or zone showing the S&P 500 moving up; the second slot or zone begins where the first one leaves off, but then the index falls below the starting point; and zone or slot three includes a period of time when the S&P 500 surpasses the high point reached in the first section or zone. The point is to show the investor how stock market activity affects an EIA. There is a profit possibility in all three zones, whether the market is going up, dropping below the original starting value, or climbing up past the previous high point.

 

Point-to-Point

Point-to-point is used to determine the accounts credit by subtracting the value of the S&P 500 at the end of the term from the beginning value.[10] The point-to-point measurement demonstrates that volatility from day to day or year to year is not important. Any and all crediting is based on only the beginning value of the index and its ending value at the end of the specified term, usually five years. Like the annual reset method, the beginning of the term is referred to as the anniversary date.

 

Contacts that use the point-to-point method of calculating gains generally have a higher participation rate than those using annual reset methods. Point-to-point methods are appropriate for the investor looking at a specific future time period. The contract owner does not care about interim values, only the value at that time period that he or she is focusing on.

 

High Water Mark

The annual high water mark with look-back is similar to the point-to-point except that it uses the highest anniversary value to calculate the gain. Therefore, over a five-year period, if the S&P 500 peaks at the end of year two and never surpasses that peak through the end of the remaining contract (years three through five), the value at the end of year two would be used. The High Water Mark method uses the highest anniversary value.

 

The annual high-water mark with look-back is usually more liquid than the point-to-point method. It is less liquid than the annual reset method. The annual high-water mark does not have a cap rate meaning that during the extremely good years the investor is credited the full gain, subject to any participation rate and minus any administration fee.

 

One cautionary note: using the highest point of the S&P 500 may sound like the best way to go, but some policies using this method of calculation credit the account only on the very last day of the term (which may be five years or more). Therefore, if the owner dies, cashes in, or annuitizes the contract prior to that last day, the value of the contract being distributed may be based on only the minimum guaranteed value. This would only apply to the annual high-water mark with look-back calculation method.

 

The high-water mark method, like point-to-point, is concerned only with two dates: the first day of the contract and a particular anniversary value. The only difference between the two methods is that the high-water mark is looking at several anniversary values in order to select the one that applies (the greatest value). Like the annual reset investor, the high-water mark investor has many chances to hit a high point. The point-to-point contract usually has a higher participation rate than the other two methods.

 

Actual Earnings

The index benefit is the amount that an investor actually earns. How much that is depends on four things:

 

1.    The index used, which is usually the S&P 500, and how much it increases.

2.    The participation rate, which means the amount or percentage of gain that the investor is entitled to.

3.    What index credit period and method is used.

4.    If a cap applies, the cap rate, which would be relevant only during a very good period.

 

Like any investment, an Equity-Indexed Annuity must give up some things in order to provide others. There is never a free lunch. It is not possible to tell which EIA contract is better than another by looking at just one component. The contract that results in comparatively lower index increases often has a higher participation rate; some participation rates are higher than 100 percent and have no cap. The index benefit depends on the four elements above plus the kind of stock market that is experienced during the contract period.

 

So, how does an investor know which method to use? Like so much in the investment world, a crystal ball would help. The annual reset is best during a typical or average stock market. The Point-to-Point is best when the market has a very high number of good years. The Annual High-Water Mark with Look-Back is often best when there is lots of volatility in the market experiencing lots of ups and downs.

 

Monthly Averaging

 

Several Equity-Indexed Annuities will determine any increase based on the indexs average value over a specified time period. Therefore, a product could use the annual reset method but did not use the year-end value of the index. Rather, such a product might use the monthly changes in the S&P 500 and then average the changes by adding up all 12 month-end figures and dividing by 12, and then subtracting the starting point from this figure.

 

Averaging smoothes out the ups and downs of the stock market. Months that experience downs are less damaging when averaged in with months that are up. On the other hand, if the stock market is moving upward overall, results are dampened and the investors gains can be reduced dramatically. Like all investments, there can be good results from averaging, but there can also be bad results, depending upon the stock market. Over the past 100 years about one in every four years has been a down year.

 

EIA contracts that use averaging in some form often have no cap rate and may have a participation rate that is close to or even exceeds 100 percent. The average reset contract using averaging could have its results bumped up.

 

Some EIA contracts limit the annual S&P 500 increase to a maximum percentage (the cap rate). This limit is on a per annum basis meaning that if the index goes up 4 percent in year one, 12 percent in year two, and 20 percent in year three, the maximum increase credited in year three would be 14 percent, even though the average annual return for these three years is 12 percent (adding the three years together and dividing by three).

 

Premium

Like fixed-rate annuities, most EIA contracts allow only a single one-time investment, referred to as a single premium. If additional funds become available for investing, a second or third contract was be entered into since it is not possible to add them to an existing Equity-Indexed Annuity. The second and third contract will not necessarily be the same as the first one, even if taken out with the same insurer. The minimum deposit will depend upon the insurer, but most range from $5,000 to $10,000 for nonqualified money. Qualified contracts may allow less since they may apply to IRAs, Keoghs, and 401(k) Plans.

 

Some insurers have contracts that allow flexible premiums. In other words, it is possible to add money to an existing annuity. It may even be possible to set up systematic payment plans for as little as $100 per month.

 

Vesting

Most annuities should be thought of as long-term. Only a few are designed for short-term goals. Some EIA contracts limit withdrawals by having a vesting schedule. A vesting schedule outlines the amount that can be withdrawn on a yearly basis without penalty. While most annuities have yearly withdrawals, usually 10 percent, allowed without penalty Equity-Indexed annuities may allow more without a penalty or surrender charge. Eventually such limitations end, but it does allow more liquidity than may otherwise be possible.

 

EIAs that use averaging or point-to-point methods of calculating gains often have very limited liquidity during the contract period since any gains are not calculated until the end of the period. This means that the investor may have to wait four to eight years before gains are realized. A contract that computes gains using the annual reset method can calculate and credit gains at the end of each year. As a result, they provide the greatest liquidity.

 

Even with gains that are calculated frequently there may not be liquidity without penalty for the investor until the very end of the contract. The problem of illiquidity of gains is due to surrender penalties that equals the gains or by having a vesting schedule that stays at zero percent until the end of the term.

 

Any withdrawal made by the investor during the contract period can affect the overall returns since gains are computed during the contract period. When you compare a contract that experienced withdrawals to one that did not, the difference is dramatic.

 

An EIA may allow free withdrawals if the contract owner becomes terminally ill or confined to a nursing home. Upon the death of the annuitant, which may or may not be the same as the contract owner, there are no surrender charges. The beneficiaries will receive the then-current value of the contract and probate is avoided.

 

Minimum Guaranteed Surrender Value

In order to fulfill requirements of the National Association of Insurance Commissioners a specified level of protection must be given to all EIA and other annuity investors. The most commonly used method requires the insurer to pay at least 90 percent of what was invested plus 3 percent per year upon contract surrender, regardless of when that happens. This means that under the worst case scenario the investment is made whole by the end of the fourth year. However, any remaining surrender charges would be subtracted from the contract values.

 

Surrender Charges

Annuity contracts commonly contain surrender charges for early withdrawal. What is early? That will depend upon the contract since there are different lengths of time involved. Any money withdrawn above any allowed free withdrawals will be subject to a surrender charge by the insurer. The IRS may also levy a penalty if the annuitant is not yet 59 years old.

 

The surrender charge lasts for the term stated in the contract. It may be a level amount or it may be a gradually decreasing amount, again, depending upon contract terms. Fixed rate and variable annuities usually have a declining surrender fee, whereas an Equity-Indexed annuity typically has a surrender fee that remains level. In addition, an EIA surrender fee is typically higher than similar charges for a variable or fixed-rate annuity.

 

If the Equity-Indexed annuity has no specified surrender charges, it is probable that any credited index increases are subject to a vesting schedule, which could be greater than a surrender charge. Vesting schedules and surrender charges are necessary in order to keep the investment with the insurer during bear markets. In an EIA, surrender charges and vesting schedules typically last for the duration of the term or contract period.

 

Regulation

The National Association of Insurance Commissioners rather than the Securities and Exchange Commission (SEC) regulates most EIAs. An insurer can register its equity indexed annuity product with the SEC and must under certain circumstances. EIAs that are registered with the SEC may only be sold by brokers with both a securities license and an insurance license. Like a mutual fund investor, the EIA investor must be given a prospectus at or before any investment is made.

 

It is not required that an equity-indexed annuity be registered with the Securities and Exchange Commission. If an insurer does not register a particular EIA with the SEC, all of the following conditions must be met:

 

1.    The insurer must be regulated.

2.    The insurer must assume all investment risk.

3.    The investor cannot have a separate account. Assets would be commingled just like they are with most other fixed-rate annuities.

4.    There must be a guarantee of both principal and net earnings.

5.    There must be a guarantee that the account will grow by at least some percentage amount each year.

6.    Growth in the account cannot be changed more than once per year.

7.    The contract cannot be marketed primarily as an investment.

 

Life Insurance Combined With Annuities

 

Annuity contracts are most likely to stand alone, without any life insurance component. However, there are times when the annuity may have a life insurance rider or be combined in some way with a life insurance product. It is very important to understand the difference between the function of an annuity and the function of a life insurance contract. An annuity is designed to provide the insured income during life whereas a life insurance policy is designed to provide income to a listed beneficiary after the insureds death. When the two are combined, the resulting contract can do both.

 

A universal variable life insurance policy is a life insurance contract, but it shares some characteristics of the variable annuity. The investments are placed in a separate account (usually stocks, bonds, and cash) similar to the variable annuity approach. The minimum death benefit is guaranteed and can increase. The premium remains the same. The investment returns depend on the underlying securities performance.[11]

 

The relationship between life insurance and annuities depends upon the intended result. If the intent is merely death protection, it is generally considered best to purchase a term policy and invest the difference since that will typically produce a better net return than purchasing a cash value life insurance policy. One way of buying term and investing the difference is to purchase a variable annuity with a term life rider. That enables the investor to insure their life while still investing without the costs of a cash value life insurance policy.

 

It is important to note that life insurance becomes more expensive each year as a person ages. That makes sense because the older one is the more likely he or she is to die. Obviously, at some point, term life insurance may not be practical. Some questions must be asked: Is there actually a need to insure the intended life? Does anyone rely financially upon that person? If not, why is life insurance being purchased?

 

It is important to establish the need, if any exists, for the purchase of life insurance. Life insurance is considered a part of the total investment strategy and there are reasons beyond the needs of a beneficiary for purchasing it. However, it is important that there be an understanding of why life insurance might be necessary (also when it is not). Money saved by discontinuing life insurance coverage could be available for further investing.

 

Seven-Pay Life Insurance

Seven-Pay Life insurance is a whole-life policy that is structured so that the contract owner can make tax-free withdrawals called policy loans. The term seven-pay refers to IRS regulations that require premium payments be paid in over at least seven years (although it is possible to reduce this to five years under specific circumstances) so that the life policy maintains its integrity as insurance and not just an investment that can produce tax-free income each year.

 

Combining an annuity contract with seven-pay life insurance can be a powerful investment approach. The IRS allows the investor to borrow money from the account on a tax-free basis (because it is a loan not income) from the cash value in the life insurance policy. The policy owner must make sure that insurance premiums are paid in over a minimum time period, which can be as little as five years (even though it is called the seven-pay test). As long as the seven-pay test is met, the only thing the contract owner must be conscious of is that the vehicle maintains its integrity as a life insurance contract. It is the fact that it is a life insurance contract that allows the policy owner to borrow from it tax-free. How does the owner make sure it remains a life insurance policy? By never borrowing all the cash value or canceling the policy. If cash value remains and the policy stays active, money can be freely borrowed each year indefinitely.

 

Annuitization is still possible even when used in conjunction with a seven-pay universal or whole life policy. A seven-year period certain immediate annuity that funds a universal life contact will work well with a person who has a lump sum to deposit and is interested in developing a method of tax-free income later on. While not everyone agrees with the use of the seven-pay life insurance investment method, few can dispute the advantages:

         The investor only has to make one payment.

         The exclusion ratio on the immediate annuity makes the distributions mostly tax free (about 80 to 85 percent tax free).

         During the first six years if the insured dies the beneficiary receives all the remaining payments.

         Death of the insured means an additional windfall for the beneficiary from the life insurance portion of the investment combination.

 

It is important to realize that the tax-free distributions are the result of the life insurance policy not the annuity. Distributions from an annuity will trigger a tax event. By depositing a lump sum into an annuity and requesting immediate annuitization over at least a five-year period the investor is assured that the life insurance policy will be funded for the next several years. The annuitization pays the life insurance premiums to insure the continuation of the life insurance policy. This will take care of the seven-pay test, giving the owner the ability to borrow the cash from the life policy (tax-free since it is not income, but rather a loan). The policy will not require the repayment of the loans.

 

Such a plan is mostly tax-free because some of the distributions result from the annuitization. That portion will be taxable. Annuitization, while beneficial in many cases, is not tax-free. Additionally, you cannot borrow from an annuity like you can from a life insurance policy, unless the annuity is part of a 403(b) retirement plan. By combining the annuity and the life insurance policy the investor can later take advantage of income that is 100 percent free of income taxes and receive some life insurance as a bonus (although that is typically not the actual intent of this investment strategy).

 

After seven policy years, it will be possible to add money to the life insurance side of the investment if the investor wishes. If universal life is used, the owner can add other riders, such as long-term care, catastrophic illness (crisis waivers), prime term, child or additional insured, and premium continuation for disability.

 

End of Chapter Four

United Insurance Educators, Inc.


[1] Getting Started in Annuities by Gordon Williamson, Copyright 1999, Page 54

[2] Getting Started in Annuities by Gordon Williamson, Page 42

[3] Medicare.gov, Paying for Long-Term Care

[4] Financial Planning Perspectives by the Financial Planning Association

[5] Financial-Planning.com Unwedded Bliss, published 5/10/2004 by Donald Jay Korn

[6] LIMRA, a financial services research organization

[7] Barrons Dictionary of Finance and Investment Terms

[8] Equity Indexed Annuities: Designs, Value, and Reality by Michael Ebmeier May, 2004

[9] Equity-Indexed Annuities by Gordon Williamson

[10] Getting Started in Annuities by Gordon Williamson, Page 165

[11] All About Variable Annuities by Bruce Wells, Page 215