1. Annuities
Objectives
Identify the characteristics, features, and usage of deferred annuities
Identify the characteristics, features, and usage of immediate annuities
Understand how to calculate immediate annuity payments.
Understand how to calculate the exclusion ratio for immediate annuity payments.

2. Annuities: Introduction
What is the risk that you “insure” with an annuity?
Risk Of Old Age
… basically, the risk of outliving income/wealth
The annuity product transfers this risk to an insurer

3. What is an annuity?
Financial Definition: A Stream Of Payments Through Time
“Contracts providing for the systematic liquidation principal and interest in the form of a series of payments over a period of time”

4. Insurers separate an annuity into two phases:
Annuities may be deferred or immediate
An immediate annuity has no accumulation phase
Accumulation
Payout
Investor makes cash payments to the insurance company. The money remains invested with the insurance company and is periodically credited with some growth factor
The insurance company agrees to pay the owner a specified amount periodically, beginning on a specified date.

5. Types of Annuities – just the basics
Immediate annuity: Payout begins within one year of the date the contract is established
Deferred annuity: Payout begins more than one year of the date the contract is established
Life annuity: Payouts will continue as long as the annuitant lives
Fixed period annuity: Company promises a payout for a fixed or guaranteed period of time, independent of the survival of the annuitant
Combination of life and fixed period payout: for example, the greater of ten years for the life of the annuitant
Fixed annuity: Invested in the general fixed account of the insurance company
Variable annuity: Invested in the separately managed sub-accounts selected by the annuity owner
Additional features
Guaranteed death benefits
Living benefits - company guaranteed benefits for owners or beneficiaries
That would be higher than actual investment performance would provide for
Variable annuitization
Payments fluctuate depending on the investment performance of the underlying sub-accounts

6. Taxation of Annuities Taxation is governed by IRC section 72
Accumulation phase
Growth is tax deferred
Withdrawals during this phase are taxed on a LIFO basis
Withdrawals are considered to be withdrawals of growth first and principal second
Payout phase
A portion of each payout is considered a return of principal
A portion of each payout is considered interest or growth
Calculation of those portions (the exclusion ratio) depends on the principal invested, the period of the payout and an internal growth factor for the payout period

7. Taxation - Details
An “exclusion ratio” is used to determine the amount that is taxed vs. the amount that is exempt from taxation.
Applies to each annuity payment equally throughout the payout phase
Example – Male aged 70 pays $12,000 for the annuity. His expected return throughout the payout phase is $19,200.
The exclusion ratio is 62.50%
If the monthly payment is $100, then
$62.50 is considered a return of principal
$37.50 is considered taxable income
Once the entire investment in the contract has been recovered, then 100% of each annuity payment received is taxable income

8. Taxation - Details
The expected return is the total amount the annuity owner should receive
Payments specified x life expectancy (or term certain if elected)
Life expectancy based on IRS Table V (single lives) or Table VI ( joint lives)
If annuitant dies before receiving the full amount guaranteed under a refund or period certain annuity
Balanced received will not be taxed (unless it exceeds the investment in the contract)
For joint and survivor annuities
Surviving owner excludes from income the same percentage of each payment that was excludible by the first annuitant
An income tax deduction may be available to the survivor owner to the extent inclusion of the annuity in the estate of the first annuitant generated an estate tax (IRD)

9. Taxation - Details
Partial withdrawals are subject to income tax, e.g., if the owner makes a partial withdrawal and takes a reduced annuity
If the owner takes a partial withdrawal & chooses same payments for different term
To the extent cash value exceeds investment in the contract, gain will be realized in the form of a taxable withdrawal of interest
Variable Annuities
No tax will be paid until the earlier of
Surrender of the contract
Withdrawals from the contract
Time that payments commence from the annuity
To obtain annuity treatment the underlying investments must be adequately diversified under IRS regulations

10. Taxation - Details
A different exclusion ratio is applied to variable annuities:
Example:
Male aged 65 purchases variable annuity for $20,000
Life expectancy of 20 years (Based on Table V)
He can exclude $1,000 from each payment ($20,000 / 20)
Assume at age 70 he receives only $200 ($800 less than his excludible amount)
Assume at age 70 his life expectancy is 16 years
He can add $50 ($800/16) to his $1,000 excludible amount

11. Taxation - Details
If the annuitant dies before payments received equal cost
A loss deduction allowed for the amount of un-recovered investment, as an itemized deduction
Amounts payable under a deferred annuity at the death of annuitant
Partially taxable as ordinary income to the beneficiary
Equal to excess of death benefit over gross premiums
Dividends, loans, cash withdrawals and other amounts that are taken out before the annuity starting date are taxed as ordinary income to extend the cash value exceeds the investment in the contract
LIFO basis

12. Taxation - Details
Premature Distributions are subject to ordinary income tax plus a 10% penalty tax
Tax applies to amount of distribution included in income
Penalty for premature distributions does not apply to:
Payments that are part of a substantial equal periodic payments made for life
Payments on or after age 59½
Payments made on account of contracts owner disability
Payments from qualified retirement plans and IRA’s
Payments to beneficiary after death of annuitant
Distributions under an immediate annuity contract
Annuity purchased on the termination of certain qualified employer retirement plans
Payments allocable to investment in the contract before August 14th, 1982

13. Taxation - Details If annuitant dies before annuity starting date
Cash value must be distributed within 5 years of death or
Used within one year to provide for a life annuity or installments payments not longer than the beneficiaries life expectancy
If spouse is the beneficiary, spouse can elect to become the new owner of the contract instead
If an annuity contract is transferred by gift, tax deferral allowed on the inside build-up is terminated
Tax-free build-up is allowed only to “natural persons”
For non-natural persons – income is treated as ordinary income in the year received
Some exceptions include annuities received by the executor of a decedent, annuities held by a qualified retirement plan or IRA, Annuities purchased by an employer on termination of a qualified plan

14. When should one consider using an annuity?
When a person wants a retirement income that cannot be outlived
When an individual wants a retirement income higher than their other conservative investments and is willing to have principal liquidated
To avoid probate and pass a large sum of money by contract to an heir and reduce the possibility of a will contest
When tax deferred growth is desired for an investment
When an investor wants to be free of the responsibility of investing and managing assets
As a supplement to an IRA

15. Fixed or Variable? Variable: Fixed:
Investor wants more control over the investments and is willing to bear the risk
Investor is looking for potentially increasing retirement income
Investor wants to be invested in variable sub-accounts, but also desires some aspect of risk management
Guaranteed death benefits / living benefits
Fixed:
Safety of principal is paramount
Investor wants to guarantee a level of interest
Investor desires a conservative complement to other investments

16. Advantages of Annuities
Guarantees of safety, interest rates and lifelong income
Protects and preserves person’s cash reserves
Allows investment in the market while moderating risk
Client can “time” the receipt of income and shift it into lower tax bracket years
An annuity paying the same rate of interest as a taxable investment will result in a higher effective yield
Underlying guarantees in variable annuities allow client to take on greater risk in the underlying investment options (equities, small market capitalizations, high yield bonds etc.) while still maintaining a reasonable risk exposure
Adjusted Gross Income (AGI) may be reduced in years where the annuity is held without withdrawals
Lower taxable income may be recognized during the payout phase, due to partial recovery of basis associated with each payment

17. Disadvantages of Annuities
Receipt of lump sum could result in a significant tax burden
Income averaging may not be available
Cash flow received may not keep pace with inflation
A 10% penalty tax imposed on withdrawals prior to age 59 ½
Growth in corporate-owned annuities is subject to taxation
Liquidation in the early years
Management, maintenance fees could prove expensive
Management fees and mortality charges could run from 1% to 2&1/2% of the value of the contract
Back end surrender charges
Investment earnings are taxed at owner’s ordinary income tax rate
Regardless of the source or nature of the return
Returns associated with long term capital appreciation do not enjoy the capital gains tax rate

18. Deferred Annuities Goal: Long-Term, Tax-Deferred Savings Premium types
Investment
Single (SPDA)
Ongoing (FPA)
Regular
Flexible 

19. Timely Advice from Consumer Reports
The fixed-dollar, deferred annuity offers safety of principal and, often, outstanding long-term guaranteed rates that could be very valuable over 15 or 20 years, should market-interest rates go down. (If market-interest rates go up, the insurance company would probably credit higher rates.)
It is the only investment that can provide, at your option, the security of a monthly payment for life, regardless of how long you live. These features make annuities a good way to save for retirement.

20. Types Of Deferred Annuities
Fixed
No Acquisition Charge
Investment growth based on interest earnings
Mortality Charge
Other Charges
Variable
Multiple investment options
Investment growth based on investment choices and performance

21. Disability Insurance and Annuities
RMI4115

22. Fees and Charges
Administration/contract maintenance charge − These charges cover the cost of maintaining the policy, including accounting and record-keeping.
Contingent deferred sales charge (CDSC) − The CDSC pays for sales expenses such as commissions, promotions and sales materials. It is deducted from your cash value if you surrender (terminate) your contract before the end of your surrender charge period. Be sure to check the length of your surrender charge period when evaluating a contract to buy, since it can vary.
Mortality and expense risk charge (M and E) − These charges compensate Nationwide for guaranteeing that annuity purchase rates and charges will not change, regardless of mortality rates or actual expenses.
Disability Insurance and Annuities
RMI4115

23. Fees and Charges
Premium tax − This tax reimburses Nationwide for any premium taxes levied by a state or other government entity.
Short-term trading fees − These fees compensate the underlying mutual fund and its contract owners for the negative impact on fund performance that can result from frequent, short- term trading strategies.
Underlying mutual fund expenses − These expenses are deducted from underlying mutual fund assets and pay for fund management distribution (12b-1) fees and other expenses.
Disability Insurance and Annuities
RMI4115

24. The Life Insurance Business (Sources of Income in 1975)

25. The Life Insurance Business (Sources of Income in 2004)
Disability Insurance and Annuities
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26. Sales Of Individual Annuities By Distribution Channels
Source: LIMRA International and the Insurance Information Institute

27. Net Assets of Variable Annuities, (1997-2006), in $billions

28. Disability Insurance and Annuities
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29. Disability Insurance and Annuities
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30. Individual Annuity Considerations (1997-2003)

31. Disability Insurance and Annuities
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33. Life Expectancy and the Need to Save

34. Retirement Supports: 3 Legged Stool (U.S. Model)
Social
Security
Employer Sponsored
Retirement Plans
Personal
Savings
Retirement Income

35. Tax-Deferred Savings Benefits
Investment= $25,000
I=6%
Tax Rate= 28%
Two Options
Pay yearly tax on investment gain
FV=$71,966
Defer tax on investment gain
FV=$107,297-
$23,043 = $84,254

36. Examples of Surrender Charge and Rate Differences
Source:

37. Withdrawals Partial Surrender Cash Out Annuitize Taxation:
Purchase Immediate Annuity
Taxation:
Prior To 59 ½
After 59 ½
Full Surrender

38. Flexible Premium Deferred Annuity: Constant Funding

39. Immediate Annuities Payment For Life Types Single Life, No Refund
Period Certain
Joint & Survivor
Variable Payout Based On Earnings 

40. Effect of Gender and Age on Immediate Annuity Payments
Monthly income per $1000 of deposit
Can you explain these patterns?

41. Nonparticipating Immediate Annuity Rates (Male)

42. How are Immediate Annuities Used?
Retirement Benefits
Supplemental Benefits
Legal Awards (Structured Settlements)
Parent/Handicapped Child
Private Annuities

43. Using Deferred Annuities in Retirement Plans
Annuity
No Additional Tax Benefits

44. Alternatives to Annuities
Municipal bond funds
Income exempt from federal and some state income taxes
Money can be withdrawn without tax penalty
Disadvantage
Lack of guaranteed return
Potential for capital losses if interest rates rise and bonds sold before maturity
Single Premium Life Insurance
Tax free death benefit
Tax deferred growth of cash surrender values
Withdrawals & loans subject to LIFO taxation and 10% penalty if distribution occurred before age 59 ½

45. Annuity Fees and Acquisition Costs
Investment management fees
Typically from .25% to about 1%
Administrative expense and mortality risk charge
Typically from a low of about .5% to as high as 2%
Annual maintenance charge
Typically $25 to $100
Charges per fund exchange
Usually less than $10
Some companies permit a limited number of charge-free exchanges per year
Maximum surrender charge
Varies from company to company
Generally phases out over a number of years

46. Selecting the Best Annuity
Compare costs and features in a spreadsheet
Fixed annuities – compare the total outlay with the total annual annuity payments
Variable annuities – evaluate the total returns for the variable annuity sub-accounts over multiple time periods
Morningstar and Lipper Analytical Services Inc.
Compare the relative financial strength of the company to other similar companies
Rating agencies - A.M. Best / Moody’s/ Standard & Poor’s

47. Suitability
In June 2008, Florida passed into law the “John and Patricia Seibel Act”.
The Act amends state laws with regard to the sale of annuities to senior consumers.
The Act outlines standards agents must meet to evaluate and determine suitability
Objective measures, vs. previous “reasonable” standard
More details in writing; comparisons and disclosures
New Requirements for corrective action and penalties
Disability Insurance and Annuities
RMI4115