1. Annuities Chapter 19 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company1 What is it? Annuities are contracts providing for the systematic liquidation of principal and interest in the form of a series of payment over time. –Primarily refers to the “payout” phase. –Many annuities also have an accumulation phase.

2. Annuities Chapter 19 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company2 What is it? An annuity is established when the investor makes a cash payment to an insurance company. –May be a single large cash payment or a series of periodic payments over time. –The insurance company invests the money. The money is periodically credited with some growth factor. Known as the accumulation phase of the annuity. –The insurance company agrees to pay the owner (or owners) a specified amount (the annuity payments) periodically, beginning on a specified date Known as the payout phase of the annuity

3. Annuities Chapter 19 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company3 What is it? Immediate annuity –The specified date for payouts to begin is within one year of the date the contract is established. –Only has a payout phase Deferred annuity –The specified date for payouts to begin is at least one year later –Has both an accumulation phase and a payout phase

4. Annuities Chapter 19 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company4 What is it? Life annuity –The payout phase continues for as long as the annuitant (or annuitants) live Fixed period annuity (term-certain annuity) –The company promises to pay stipulated amounts for a fixed or guaranteed period of time independent of the survival of the annuitant. Fixed annuity –Invested in the general fixed account of the insurance company.

5. Annuities Chapter 19 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company5 What is it? Variable annuity –Invested in separately managed sub-accounts selected by the annuity owner. –Has additional features to manage the risk of the underlying investments Guaranteed death benefits or newer “living benefits” “Variable annuitization” –Payments that may fluctuate up or down depending upon the performance of the underlying sub-account investments

6. Annuities Chapter 19 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company6 What is it? “Fixed annuitization” –Payments that remain the same through the payout phase –Can be occasionally increased by some set rate to keep pace with inflation This rate is pre-determined and contractual Commercial annuities –Annuities purchased from an insurance company Private annuities –Annuities purchased from a person or entity that is not in the business of selling annuities

7. Annuities Chapter 19 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company7 What is it? Annuities grow tax-deferred during the accumulation phase. –Withdrawals during this phase are taxed on a LIFO basis Withdrawals are considered to be growth first (fully taxable) and principal second.

8. Annuities Chapter 19 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company8 What is it? Payouts during the annuitization phase are split. –A portion of each payment is considered principal and a portion is deemed interest/growth. –The proportion of each is determined at the annuity’s beginning payment date and is based upon: The already accumulated growth An assumed internal growth factor for the payout period The expected length of the payout period. –All amounts distributed that are considered interest/growth are taxed as ordinary income. Regardless of the phase or timing of the withdrawal. Certain withdrawals before the age of 59 ½ may be subject to an additional 10% tax penalty.

9. Annuities Chapter 19 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company9 What is it? The primary reason annuities should be purchased are for their risk management features. –They can provide a variety of guarantees, whether protecting against: Interest rate risk Reinvestment risk Market volatility risk Risk of living too long and outliving one’s assets.

10. Annuities Chapter 19 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company10 When is the use of this tool indicated? When a person wants a retirement income that can never be outlived When an individual wants a monthly income equal to or higher than other conservative investments and is willing to have principal liquidated When the person would like to avoid probate and pass a large sum of money by contract to an heir to reduce the possibility of a will contest When a tax-deferred accumulation of interest is desired –The interest earned inside an annuity owned by an individual grows income tax-free and is not taxed until it is withdrawn.

11. Annuities Chapter 19 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company11 When is the use of this tool indicated? When an investor wants to be free of the responsibility of investing and managing assets –Applies in the case of a fixed annuity or an annuity payout As a supplement to an IRA –There are limited opportunities for pre-tax contributions to IRAs Fixed annuities would be indicated: –When safety of principal is a paramount consideration –When an investor wants a guarantee that a given level of interest will be credited to his investment for a long period of time –When a conservative complement to other investment vehicles is desired

12. Annuities Chapter 19 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company12 When is the use of this tool indicated? Variable annuities would be desired: –When an investor wants more control over his investment and is willing to bear the risk associated with his investment selections –When a person is looking for potentially increasing retirement income When an individual would like to be invested in variable sub-accounts, but desires some aspect of risk management

13. Annuities Chapter 19 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company13 Advantages The guarantees of safety, interest rates, and particularly lifelong income (if selected) give the purchaser peace of mind and psychological security. An annuity protects and builds a person’s cash reserve. –The insurer guarantees principal and interest (in the case of a fixed annuity), and the promise (if purchased) that the annuity can never be outlived.

14. Annuities Chapter 19 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company14 Advantages An annuity allows a client to invest in the market while moderating risk. –The insurer may provide guarantees of death proceeds or a certain annuitization amount (if purchased) within a variable annuity. Unavailable to a client that purchased the underlying investments directly A client can “time” the receipt of income and shift it into lower tax bracket years. An annuity paying the same rate of interest (after expenses) as a taxable investment will result in a higher effective yield. –The interest on an annuity is tax-deferred.

15. Annuities Chapter 19 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company15 Advantages A client may be able to take on greater risk in the underlying investment options while still maintaining a reasonable overall risk exposure due to the underlying guarantees. –Particularly in variable annuities Adjusted Gross Income (AGI) may be reduced in years where the annuity is held with no withdrawals. –Due to the tax-deferral features of the accumulation phase –Lower taxable income may be recognized during payout phase due to the partial recovery of basis associated with each payment. –A reduced AGI can bring tax savings, as many other income tax rules are calculated based upon AGI.

16. Annuities Chapter 19 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company16 Disadvantages Receipt of a lump sum could result in a significant tax burden because income averaging is not available. –This can be moderated if the proceeds are annuitized. The cash flow stream of a fixed payout may not keep pace with inflation. –Particularly for longer-term payout phases such as a life annuitization

17. Annuities Chapter 19 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company17 Disadvantages A 10% penalty tax is generally imposed on withdrawals of accumulated interest during the accumulation phase. –Prior to age 59½ or disability –May also apply to the annuitization phase if the annuity was not an immediate annuity and certain short payout terms are selected. If an annuity contract is held by a corporation or other entity that is not a natural person, the contract is not treated as an annuity contract for federal income tax purposes. –Income on the contract for any taxable year is treated as current taxable ordinary income to the owner of the contract regardless of whether or not withdrawals are made.

18. Annuities Chapter 19 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company18 Disadvantages If the client is forced to liquidate the investment in the early years of an annuity, management and mainte- nance fees and sales costs could prove expensive. –Total management fees and mortality charges can run from 1% to 2½% of the value of the contract. –There may be a “back end” surrender charge if the contract is terminated within the first few years. Investment earnings are taxed at the owner’s ordinary income tax rate when the owner receives payments. –Regardless of the source or nature of returns

19. Annuities Chapter 19 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company19 Tax Implications A client’s investment in an annuity is returned in equal tax-free (return of capital) amounts during the payout phase. –Any additional amount received is taxed at ordinary income tax rates. “Exclusion ratio” – Determines the amount of each period’s payment that will be considered nontaxable –Investment in Contract divided by Expected Return –Expressed as a percentage The full amount of each annuity payment received would be tax free if the investment in the contract exceeds the expected return.

20. Annuities Chapter 19 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company20 Tax Implications The excludable portion of any annuity payment may not exceed the unrecovered investment in the contract. –Unless the annuity started before January 1, 1987 –“Unrecovered Investment in the Contract” The policyowner’s premium cost, reduced by any dividends received in cash or used to reduce premiums, and by the aggregate amount received under the contract on or after the annuity starting date to the extent it was excludable from income. –The unrecovered investment in the contract is reduced each time an annuity payment is made by the amount of the payment that is excluded from income by the exclusion ratio. –Once an annuitant has fully recovered his investment in the contract (which generally occurs at the end of the expected payout term), 100% of each subsequent payment will be taxable.

21. Annuities Chapter 19 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company21 Tax Implications Some annuities provide a refund if the annuitant dies before recovering his entire cost. –The present value of the refund option must be ascertained by government tables and subtracted from the investment in the contract. “Expected Return” –The total amount that the owner (or owners) should receive given the payments specified (which include an assumed internal growth rate) multiplied by the certain term or life expectancy according to the governments tables. Table V for single lives Table VI for joint and survivor annuities

22. Annuities Chapter 19 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company22 Tax Implications When an annuitant dies before receiving the full amount guaranteed under a refund or period certain life annuity, the owner or beneficiary receiving the balance of the guaranteed amount will have no taxable income. –Unless the amount received by the beneficiary plus the amount that had been received tax free by the annuitant exceeds the investment in the contract.

23. Annuities Chapter 19 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company23 Tax Implications If the refund or commuted (present) value of the remaining installments is applied by the owner or beneficiary to purchase a new annuity, payments received will be taxed under the annuity rules to the beneficiary. –The refund amount will be considered the beneficiary’s investment in the new contract and a new exclusion ration must be determined.

24. Annuities Chapter 19 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company24 Tax Implications If the owner was receiving payments under a joint and survivor annuity, the surviving owner excludes from income the same percentage of each payment that was excludable by the first annuitant. –Assuming that the joint annuitants were joint owners –An income tax deduction may be available to the survivor owner/annuitant to the extent inclusion of the annuity in the estate of the first to die generated an estate tax. When an owner makes a partial withdrawal from the contract and takes a reduced annuity for the same term, a portion of the amount withdrawn will be subject to income tax.

25. Annuities Chapter 19 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company25 Tax Implications When an owner makes a partial withdrawal from the contract and chooses to take the same payments for a different term, gain will be realized in the form of a taxable withdrawal of interest. –To the extent the cash surrender value of the contract exceeds the investment in the contract. The purchase of a variable annuity is not taxed on income during the accumulation period. –No tax will be payable until the earlier of: The surrender of the contract Withdrawal from the contract The time payments under the annuity begin (annuitization)

26. Annuities Chapter 19 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company26 Tax Implications “Exclusion ratio” for a variable annuity –Investment in Contract divided by Number of Years of Expected Return –If there is a period certain or refund guarantee, the investment in the contract is adjusted accordingly. –If payments drop below the excludable amount in any given year, the annuitant can elect to redetermine the excludable amount in the next tax year in which he receives an annuity payment.

27. Annuities Chapter 19 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company27 Tax Implications If an annuitant dies before the investment in the contact has been recovered, a loss deduction can be taken by the owner for the amount of the unrecovered investment. –It is an itemized deduction, but not a miscellaneous deduction It is not subject to the 2% floor. It can be taken by the estate or any other beneficiary

28. Annuities Chapter 19 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company28 Tax Implications Amounts payable under a deferred annuity contract at the death of an annuitant (prior to the contract’s maturity) will be partially taxable as ordinary income to the beneficiary. –The taxable amount is equal to the excess of: The death benefit (plus aggregate dividends and any other amounts received tax free), over Total gross premiums

29. Annuities Chapter 19 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company29 Tax Implications Amounts withdrawn before the annuity starting date are taxable as income the the extent that the policy cash value exceeds the investment in the contract. –Results in a LIFO type of treatment where all interest/growth is taxed before any tax-free return-of-capital payments can occur. –“Interest-first” rule: Imposed to discourage the use of annuity contracts as short-term investment vehicles A loan is considered a cash withdrawal –To the extent the contract is used as collateral for a loan, amounts borrowed will be taxable. To the extent that the amount received is less than or equal to the gain inherent in the contract

30. Annuities Chapter 19 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company30 Tax Implications “Premature” distributions are subject to a penalty tax of 10%. –Penalty does not apply to the following: Payments that are part of a series of substantially equal periodic payments made for the life (or life expectancy) of the taxpayer or the joint lives (or joint life expectancies) of the taxpayer and his beneficiary Payments made on or after the time the contract owner becomes age 59½ Payment made on account of the contract owner’s disability Payments made from qualified retirement plans and IRAs Payments made to a beneficiary on or after the death of the annuitant Distributions under an immediate annuity contract An annuity contract purchased on the termination of certain qualified employer retirement plans and held until the employee separates from service Payments allocable to investment in the contract before 8/14/1982

31. Annuities Chapter 19 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company31 Tax Implications If an annuity owner dies before the starting date of the annuity payments, the cash value of the contract must either be distributed within 5 years of death or used within 1 year to provide a life annuity or installment payments payable over a period not longer than the beneficiary’s life expectancy –Spouse can elect to be the new owner of the contract

32. Annuities Chapter 19 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company32 Tax Implications If the annuity contract is transferred by gift, the tax deferral on the inside build up that was allowed to the original contract owner is terminated. –The donor of the gift is treated as having received non-annuity income in an amount equal to the excess of the cash surrender value of the contract over the investment in the contract at the time of the transfer. Tax-free build-up is allowed only to “natural persons.”

33. Annuities Chapter 19 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company33 Tax Implications Exceptions from the “natural persons” rules allow tax- free build-up of the following annuities: –Annuities received by the executor of a decedent at the decedent’s death –Annuities held by a qualified retirement plan or IRA –Annuities considered “qualifying funding assets” Used to provide funding for structured settlements and by property and casualty insurance companies to fund periodic payments for damages –Annuities purchased by an employer on termination of a qualified plan and held until all amounts under the plan are distributed to the employee or his beneficiary –Annuities which are “immediate” Those which have a starting date no more than one year from the date the annuity was purchased and provide for a series of substantially equal periodic payments to be made at least annually

34. Annuities Chapter 19 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company34 Alternatives Municipal Bond Funds –The income they produce is exempt from federal and, in many cases, state income tax. Single Premium Life Insurance –Offers many of the same advantages of annuities, but incorporates a death benefit at issuance that is higher than the cash deposit Mutual Funds –Tax on the capital appreciation of the assets in a mutual fund is deferred until the gains are realized. –Realized gains are taxed as either long- or short-term capital gains, depending on the holding period. All gains and income on the assets in the separate accounts of a variable annuity are taxed at ordinary income rates.

35. Annuities Chapter 19 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company35 Where and How do I get it? Almost all life insurance companies offer annuities. –These companies distribute annuities to customers through: Life insurance agencies Many stock brokerage firms Independent insurance agents and financial planners Independent insurance brokerage firms Direct to consumers through the mail and internet Variable annuities can only be offered by agents who are licensed and who have passed the applicable securities examination. –Prospective buyers must be given a prospectus.

36. Annuities Chapter 19 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company36 What fees or other costs are involved? There are five typical fees or charges that are usually incurred when purchasing annuities, particularly variable annuities. –Investment Management Fees –.25% to 1% –Administration Expense and Mortality Risk Charge –.5% to 2% –Annual Maintenance Charge – $25 to $100 Often waived once total investments exceed a specified amount –Charge per Fund Exchange – $0 to $10 Limited amount of charge-free exchanges per year –Maximum Surrender Charge Vary by company and generally phase-out over a number of years Fees should be listed in prospectus

37. Annuities Chapter 19 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company37 How do I select the best of its type? Compare the costs and features of selected annuities. –Consider all of the five costs discussed above as well as how much can be withdrawn from the contract each year without fee. Compare the total outlay with the total annual annuity payment in the case of fixed annuities. –Incorporate time value of money In an analysis of variable annuities, evaluate the total return for the variable annuity sub-accounts over multiple time periods. Compare the relative financial strength of the companies through services such as A.M. Best. –Insist on a credit rating of A+.

38. Annuities Chapter 19 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company38 Where can I find out more about it? Newspapers –Wall Street Journal Three major statistical sources –A.M. Best Co –Lipper Analytical Services Inc. –Barron’s Insurance brokerage firms