A ANNUITIES Published in the United States of America By: The CE Source, LLC 1.800.994.3040 www.StateCE.com Copyright 2005: The CE Source, LLC All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording or otherwise, without the prior written permission of the Publisher. Although great effort has been made to ensure this publication contains accurate and timely information, it is provided with the understanding that the author and publisher is not engaged in rendering legal, accounting, tax, or other professional service. If professional advice is required, the services of a competent advisor should be sought.
Transcript
AANNNNUUIITTIIEESS
Published in the United States of America By: The CE Source, LLC
1.800.994.3040 www.StateCE.com
Copyright 2005: The CE Source, LLC All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording or otherwise, without the prior written permission of the Publisher.
Although great effort has been made to ensure this publication contains accurate and timely information, it is provided with the understanding that the author and publisher is not engaged in rendering legal, accounting, tax, or other professional service. If professional advice is required, the services of a competent advisor should be sought.
Parties To An Annuity ................................................................................................. 5
The Insurer ......................................................................................................................................... 5 The Contract Owner.......................................................................................................................... 5 The Annuitant .................................................................................................................................... 6 The Beneficiary .................................................................................................................................. 6 Multiple Titles .................................................................................................................................... 7
Chapter Three .............................................................................................. 8
Equity-Indexed Annuities .............................................................................................................. 14 The European Method.................................................................................................................................15
The Asian Method........................................................................................................................................15 The High-Water-Mark Method ..................................................................................................................15 The Low-Water-Mark Method ...................................................................................................................15 The Annual Reset (Cliquet or Ratchet) Method.......................................................................................15 Guaranteed Return ......................................................................................................................................15
Single Premium Retirement Annuity (SPRA2) ........................................................................... 16 Flexibility and Control.................................................................................................................................17 Guaranteed Death Benefit...........................................................................................................................17
Single Premium Immediate Annuity (SPIA) ............................................................................... 17 Safe from Market Fluctuations ...................................................................................................................17 Tax-Qualified Money...................................................................................................................................17 Guaranteed Period Certain SPIA ...............................................................................................................18 Guaranteed Total Amount SPIA................................................................................................................18
Single Premium Fixed Annuity..................................................................................................... 18 Interest Rates.................................................................................................................................................19 Principal Guarantee .....................................................................................................................................19 Periodic Partial Withdrawals (PPW) .........................................................................................................19
Variable Annuities........................................................................................................................... 19 Investing In a Variable Annuity.................................................................................................................20 Advantage and Disadvantage of Variable Annuities .............................................................................21 Fair Rate of Crediting ..................................................................................................................................21 Deferred Taxes on Policy Gains .................................................................................................................22 Ordinary Income Tax vs. Capital Gains Tax ............................................................................................22
Costs Associated with a Variable Annuity .................................................................................. 22 Surrender Charge.........................................................................................................................................22 Maintenance Fee...........................................................................................................................................22 Fund Operating Expenses...........................................................................................................................22 Insurance-Related Charges .........................................................................................................................22
Chapter Five ............................................................................................... 29
Features and Benefits of Annuities ......................................................................... 29
Required Minimum Distribution (RMD) Option........................................................................ 29 Withdrawal Feature ........................................................................................................................ 29 Settlement Alternatives .................................................................................................................. 30 Death Benefit .................................................................................................................................... 31 Survivor Benefit Plan (SBP)............................................................................................................ 31
Amount of Annuity for Beneficiary of Person Providing Standard Annuity......................................31 Amount of Annuity for Beneficiary of Person Providing Reserve-Component Annuity..................32 Adjustments in Annuities ...........................................................................................................................32 Periodic adjustments (colas) .......................................................................................................................32 Rounding dow..............................................................................................................................................32 Termination of Annuity ..............................................................................................................................32
Riders ................................................................................................................................................ 32 Living Needs Benefit Rider.........................................................................................................................32 Unemployment Benefit Rider.....................................................................................................................32
Tax-Deferred Growth...................................................................................................................... 32 The Insurance Component............................................................................................................. 33 Tax-Free Exchanges......................................................................................................................... 34 Transferring Annuities ................................................................................................................... 34 To An Heir........................................................................................................................................ 34 To A Spouse ..................................................................................................................................... 35 Funding a Life Insurance Policy.................................................................................................... 35
Chapter Six ................................................................................................. 37
Phases of An Annuity................................................................................................. 37
The Accumulation Phase................................................................................................................ 37 The Payout, Distribution, or Annuitization Phase ..................................................................... 37 Break Even Phase ............................................................................................................................ 38
Investment Options .....................................................................................................................................43 Family Rating................................................................................................................................................43
Categories ......................................................................................................................................... 43 Aggressive Growth Subaccounts ...............................................................................................................43 Balanced Subaccounts .................................................................................................................................44 Corporate Bond Subaccounts .....................................................................................................................44 Global Stock Subaccounts ...........................................................................................................................45 Government Bond Subaccounts.................................................................................................................46 Growth Subaccounts....................................................................................................................................46 Growth and Income Subaccounts ..............................................................................................................46 High-Yield Bond Subaccounts ...................................................................................................................47 Specialty Subaccounts .................................................................................................................................47 Utility Stock Subaccounts............................................................................................................................48 World Bond Subaccounts............................................................................................................................49
Special Annuity Classifications ............................................................................... 60
Private Annuity ............................................................................................................................... 60 Benefit of Private Annuity ..........................................................................................................................60
Gift Annuities................................................................................................................................... 61 Railroad Employee Annuities........................................................................................................ 62
Age and Service Annuity ............................................................................................................................63 Disability Annuity........................................................................................................................................63 Supplemental Annuity ................................................................................................................................64 Current Connection Requirement..............................................................................................................64 Spouse Annuities .........................................................................................................................................65 Employee and Spouse Annuity Estimates................................................................................................66 Railroad Retirement Maximum .................................................................................................................66 Working After Retirement ..........................................................................................................................66 When Annuities Stop...................................................................................................................................67
Annuities and Medicaid ............................................................................................ 69
Annuities as a Shield....................................................................................................................... 69 Immediate Annuity AS Qualification for Medicaid ................................................................... 71 Using Annuities to Shelter Nonexempt Assets ........................................................................... 71 Types of Annuities .......................................................................................................................... 72
Life Only Immediate Annuities..................................................................................................................72 Life Annuities with Refund Provisions.....................................................................................................72 Period Certain Annuities ............................................................................................................................73 Staged Annuities ..........................................................................................................................................73
Life Annuity..................................................................................................................................................82 Joint-and-Survivor Annuity........................................................................................................................82
Tax-Deferred Advantage.............................................................................................................................83 Penalty Tax....................................................................................................................................................83 Probate...........................................................................................................................................................83 Compared With Other Investments ..........................................................................................................83
Negative Features of Annuities ..................................................................................................... 84 Special Features of Annuities ........................................................................................................ 85
CHAPTER ONE IINNTTRROODDUUCCTTIIOONN TTOO AANNNNUUIITTIIEESS
The most crucial economic challenge that our country faces is to rediscover the old habits of saving and investing that made us the most affluent nation and the leading economic power on earth. It is crucial if some 75 million Americans who will turn 65 in the first decades of the new century are to have a reasonable prospect of enjoying the freedom that comes with a financially secure retirement. It is also crucial because money saved and invested does not sit idly in a cookie jar. It funds investment in new plants and equipment, in research, development, and training. In short, it fuels the entrepreneurial drive that will keep America on top in an increasingly competitive global economy.
The Baby Boomers From 1927 to 1945 there were 49 million babies born in the United States. The end of World War II, greeted in this country with great relief and an outpouring of optimism , marked the beginning of a baby boom that lasted two decades. From 1946 to 1964, 76 million babies were born. The impact of this huge group of babies cannot be looked at in isolation. There are three separate and unprecedented trends that are converging together to actually turn the United States upside down. These three trends are:
• A senior boom
• A birth bust
• The aging of the baby boomers
Throughout all recorded history, only one in ten people could expect to live to the age of 65. Today, eight out of ten Americans will live past 65. This senior boom is going to have an impact on certain industries in the stock market. The average age of the buyers of American made luxury cars is 65 and grandparents buy 40% of all the toys sold.
Twenty percent of baby boomers will have no children at all and another 25 percent will have only one. This fact is attributed to our changing economic world. When we were an agricultural economy, it was important for parents to have cheap, available labor to help run the farm. What better source than one’s own children? Now, however, we have evolved to an industrial, information, and service economy. Children are no longer an asset; they actually are a liability—Long-term cost with no economic return.
Over one-third of all living Americans today is a baby boomer. When boomers arrived as infants, a thriving diaper and baby food industry was born along with a swelling of the ranks of pediatricians. Toddler baby boomers became the impetus behind the creation of a huge day care and kindergarten industry. When boomers entered elementary schools, new classroom were built all across the nation. Between 1950 and 1975, the high-school population doubled, and the number of college students
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rose from 3.2 million in 1965 to 9 million in 1975. Those 76 million teenagers made McDonald’s and the whole fast-food industry become so successful.
As boomers continued to age in the ‘70s and began buying their first homes, real estate prices appreciated as they never had before. Then in the ‘80s, boomers began to focus on self-improvement and career advancement. Pop psychology literature dealing with personal growth came into being and grew. The circulation of publications such as the Wall Street Journal, Forbes, and Fortune skyrocketed; CNN and CNBC came out of nowhere. Now as we enter a new millennium, these baby boomers are thinking about retirement. According to the Social Security Administration, 10 million baby boomers are going to live to age 90.
Retirement There are many good retirement plans available to the investor, but annuities offer a big advantage—a whole new dimension to retirement assets—that one should consider, no matter how much money he has already put away otherwise for his retirement. Annuities have no annual contribution limits.
While there are tax laws that control how much one can put each year into a 401(k), IRA, and almost every other retirement plan, one can put as much into an annuity as he likes. Money that is put into a 401(k) is salary deferred; so taxes are deferred. IRA contributions, depending on one’s eligibility, may also be tax-deductible and all the earnings or gains are tax-deferred.
The money that one puts in an annuity earns interest that accumulates tax-deferred until he begins to make withdrawals or begins to receive his regularly scheduled payments. Annuity payments are composed of two parts: the interest on the money one has invested, plus a return of the money that was invested originally. The return of principal is not taxed.
As in any investment that is tax-deferred, money invested in an annuity grows rapidly for three reasons:
• The original investment earns interest
• That interest earns interest, since it is automatically compounded
• The money one would ordinarily pay out for taxes remains invested—earning interest.
Historical Background Fixed annuities date back to 1812, but it was the Tax Reform Act of 1986 that really made these products popular. Variable annuities came into being in 1952, through the work of William Greenough, an economist with the Teachers Insurance and Annuity Association. Greenough wanted a retirement vehicle comprised of equities, to counterbalance post-World War II inflation.
As income tax rates increase and company retirement benefits decrease, individuals must take on a larger and larger role in their own retirement planning. Annuities have become one of the primary tools for warding off taxes and building a larger nest egg. Annuity sales have multiplied rapidly over the last fifteen years.
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Defining Annuities An annuity is an investment one makes through an insurance company. It represents a contractual relationship between an individual and the company. Although annuities are offered only by the insurance industry, they do not have anything to do with life insurance or any other type of insurance coverage. Annuities are marketed and sold through brokerage firms, insurance agencies, banks, savings and loan institutions, financial planners, and investment advisors. When an individual purchases or invests in an annuity, the insurance company gives him certain assurances. The guarantees depend upon the type of annuity. There are two different types of annuities -- Fixed Annuities and Variable Annuities. The fixed annuity has a set rate of return and the variable annuity allows the investor to choose from a series of portfolios that range from conservative to aggressive.
Annuities purchased from an insurance company are called “commercial annuities” while those purchased from a party who is not in the business of selling annuities are called “private annuities.” Technically, the living proceeds received from a life insurance contract are also considered annuities if they consist of payment of both principal and interest. A life annuity promises that as long as the annuitant lives payments will be continued. In other words, the income stream can never be outlived. Life annuities are priced based on the expected mortality experience of a large group of annuitants.
Annuities can be distinguished from life insurance policies by virtue of their different purposes. Life insurance has often been described as protection against dying too soon, while an annuity is considered protection against living too long. Although these descriptions have become a cliché in the insurance business, they are apt. Life insurance protects the insured’s survivors against financial problems that arise when the insured dies before accomplishing financial security goals. An annuity, on the other hand, protects the person receiving annuity funds -- the annuitant -- against financial problems that arise from living beyond the earning years that pay for everyday living expenses.
Fixed Annuities Much like CD's, fixed annuities give one a fixed interest rate for a fixed time period - usually 1-10 years thus guaranteeing a fixed rate of interest for the life of the contract. If the insurer guarantees the rate for one year, he announces the fixed return for the year ahead at the end of each year. The rate depends on the insurer’s current investment portfolio. The major advantage of a fixed annuity is security. Even if one makes a withdrawal from time to time, the balance remaining in the annuity will continue to earn the fixed rate that was guaranteed.
Fixed-Immediate Annuities The investor puts in a fixed sum of money, and the annuity begins paying him income immediately, or no later than twelve months after the annuity was bought. People who buy immediate annuities are usually trying to supplement their retirement income, and have found the income being paid by the annuity appealing because it can be used primarily as a systematic liquidation of principal and interest over their lifetimes, no matter how long they live.
Variable Annuities A variable annuity allows one to direct his investment among several types of investment funds while enjoying the tax-deferred benefits of the annuity product. The return fluctuates with the stock, bond, and money markets. Variable annuities, have additional insurance-related expenses, may be
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subject to surrender charges, and are generally a longer term investment than a mutual fund. With variable annuities, one bears the investment risk.
Deferred Annuities They accumulate their earnings tax-deferred. Most deferred annuities allow the investor to withdraw once a year, free of a company charge—up to 10% of the total value of his annuity. For amounts over 10% withdrawn in a single year, the insurance company may impose a charge. When the money is taken out, the tax laws require that the earnings, which are taxable, be withdrawn first. The excess in the withdrawal would be a return of one’s investments, and so would not be taxed. Deferred annuities come in three flavors: fixed, variable, and modified guarantee.
A Fixed Annuity guarantees a fixed rate of interest for the life of the contract. The major advantage of a fixed annuity is security. Some fixed annuities offer a fixed rate of interest for a specified period of time. Even if one makes a withdrawal from time to time, the balance remaining in the annuity will continue to earn the fixed rate that was guaranteed.
Variable Annuities appeal to the investor who wants the opportunity for the higher returns that may come from assuming higher risks. The insurance company offers as investment options a diversified portfolio of securities—for example, stocks, bonds, or other securities.
A Modified Guarantee Annuity is similar to a fixed annuity with one major exception. Usually, if funds are left to the end of each guarantee period one chooses, the principal and interest are guaranteed. However, if funds are withdrawn prior to the end of the guarantee period, a market value adjustment may happen. If prevailing interest rates have increased since the commencement of the guarantee period, the adjustment will be negative. Conversely, if the rates have gone down, the adjustment will be positive. This kind of annuity generally offers more guarantee period interest rate choices (one to ten years) and thus a set of varying interest rates, both short and long term. Because of this “market value adjustment” feature, interest rates will generally be somewhat higher than in a conventional fixed annuity.
Payout Options The annuity payout options will be discussed more in later chapters. They are:
♦ Annuity Certain ♦ Lump Sum Distribution ♦ Cash Refund Option ♦ Joint and Survivor Option ♦ Installment Refund Option ♦ Life or Straight Life Option ♦ Life with Period Certain
CHAPTER TWO PPAARRTTIIEESS TTOO AANN AANNNNUUIITTYY
There are always four parties to each annuity. These parties are the insurer, the contract owner, the annuitant, and the beneficiary.
The Insurer The insurer is the one who is licensed to sell annuities and is the agreement between an individual and an insurance company. This person may be:
• in a local bank
• a financial planner
• a brokerage firm
but it will always be an individual who is licensed to sell annuities. There are over 2,000 insurance companies in the United States; several hundred of these insurers deal in annuities. The insurance company that an individual chooses is also know as the insurer, and he or she will be the person investing the money. In addition to investing an individual’s money, the company makes certain promises. These assurances and the Term of the agreement are contained in the annuity contract. The contract spells out what can and cannot be done. Items such as additional investing, withdrawals, cancellations, penalties, and guarantees are all defined in the contract.
Whether or not the annuity is purchased directly through the insurance company or through any of its authorized agents, the investment contract is always written between the investor and the insurance company. The insurance company offering a particular annuity will invest an investor's money according to his own individual needs and financial objectives. Part of the contract with the insurance company will identify in what ways the investor wants his money handled, i.e. growth, high yield, small cap, etc. As part of the annuity contract between the investor and the insurance company, the insurance company will make certain promises to the investor and will identify when and how much money can be added to a particular holding, withdrawals, cancellation penalties, and all the guarantees that the insurance company is willing to extend.
The Contract Owner The contract owner is the person or the couple who invests in the annuity. A minor child can be the contract owner only if a guardian or custodian is prominently listed. Because the investor is the owner of the investment, he can gift the annuity contract to anyone or any entity at any time. It is their money, they decide among the different options offered. A contract owner has the right to add more money, make investment decisions and changes, and withdraw all or a part of the investment; change the parties to the investment, and to terminate the agreement. The contract owner is similar
C H A P T E R 2 : P A R T I E S T O A N A N N U I T Y
to the purchaser of a mutual fund or bank CD. When an individual buys a mutual fund, he or she is the owner. This individual has the right to invest more money, liquidate the entire account, take some or all of the money out, and change the title of the account or its ownership. Since the contract owner controls the investment, he or she can gift or will part or the entire contract to anyone or any entity at any time.
The Annuitant The annuitant is similar to the insured in a life insurance policy. The annuitant is the individual or entity that is named on the annuity contract and the annuity will remain in force until the contract owner makes any changes or the annuitant dies. The annuitant, unless it is the contract owner, has no say in or control of the annuity contract. The annuitant does not have the power to make withdrawals, deposits, change the names of the parties to the agreement, or terminate the contract. Just as when an individual purchases life insurance on someone else, the annuitant must also sign the annuity contract. The person that this individual names as the annuitant can be anyone: the annuitant, his or her spouse, parent, child, relative, friend, or neighbor. The only qualification is that the named annuitant is a person currently living who is under a certain age.
The maximum age of the proposed annuitant depends on the insurance company. Most companies require that the annuitant be under the age of 75 when the contract is initially signed. Other companies set a maximum age of 70 or 80. It is important to note that the contract may still stay in force after the annuitant reaches the maximum age. Most annuities allow the contract owner to change the annuitant at any time. The only stipulation is that the new annuitant must have been alive when the contract was originally set up.
The Beneficiary The beneficiary is like a vice president of a country because he or she is of little value until the death of a certain individual. In the case of an annuity, the beneficiary is waiting for the death of the annuitant. And, like the beneficiary of a life insurance policy, the beneficiary of an annuity has no voice in the control or management of the policy. The only way in which the beneficiary can prosper from an annuity is upon the death of the annuitant. The named beneficiary(s) can be
• children
• friends
• relatives
• spouses
• neighbors
• trusts
• corporations
• partnerships
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The annuity application allows for multiple beneficiary designations of varying or similar proportions such as 25% to Shannon Smith, 15% to Rees Smith, 10% to Lolly Frasier, and 50% to the Reiser Family trust.
In the case of a married couple, it is common for the contract owner to be either one or both spouses and for the annuitant to be one or both spouses. This type of multiple titling is designed to protect the assets of the couple in the case of the annuitant’s untimely death. After all, most couples would not want the annuity proceeds to go to a charity or child while one or both spouses were still alive. A single person, widow, or widower will usually name himself or herself as the contract owner and annuitant while listing a loved one or entity as the beneficiary. By making such an election, the individual retains complete control and dominion over the investment during his or her lifetime. Upon the death of the annuitant, the money would automatically pass to the intended heir. The contract owner can change the beneficiary or beneficiaries at any time; consent by the existing beneficiary(s) is not necessary.
If the contract owner dies prior to the death of the annuitant, neither the annuitant nor the named beneficiary has rights to the investment. The deceased legal heirs, named in a legal Last Will and Testament, will inherit the investment. If the contract owner dies without benefit of a valid will, the investment is passed to survivors as determined by interstate succession. The contract owner can change the beneficiary at any time without needing to advise or get the consent of the existing listed beneficiary. At the time that an annuity contract is executed, the insurance company will need to know several important facts: Name of the contract owner, Name of the annuitant, and
Name of the beneficiary.
Multiple Titles There may be four parties involved in an annuity investment but there may not be four individuals. The same person can hold multiple titles. So, one individual could be the contract owner and beneficiary or one individual could be the owner, annuitant, and beneficiary. In fact, any combination is acceptable. However, if the contract owner chooses an entity, the entity can only be the contract owner and or beneficiary, a living individual under a certain age, but a couple cannot be named as the annuitant. The insurer is always an insurance company and in order to change the insurers he or she must change insurance companies.
Payment Options There are three ways to purchase an annuity. They are Payout Immediate' Single Payment Deferred, and Periodic Payment Deferred.
Purchase Method Immediate Pay Under this purchase method, the investor gives the insurance company one single lump sum payment. And usually, in about 30 days the insurance company will begin monthly payments. A person who is still working and not near retirement (10 - 40 years away) would ordinarily not choose this method. This would be an alternative for someone who has a large lump sum of money and is at or near retirement and wishes to begin payout immediately.
The immediate-pay annuities, sometimes called lifetime annuities are purchased typically by people in retirement who want to provide a guaranteed stream of income for themselves. They may get the lump sum from their pension plan distribution or from their IRA or Keogh plan. One of the disadvantages with immediate-pay annuities is that by locking in a set amount of income, one’s earnings can get eaten away by inflation.
Payment Options It is not necessary to establish which payout option one may choose until he is reaching the point when he would like to receive his annuity benefits. Only with an immediate annuity does one need to establish his payout options in the initial contract. The various payout options are listed below.
Period Certain Payments are made over a fixed period such as 5,10, or 20 years. At the annuitant's death, the beneficiary continues to receive the payments until the end of the fixed period.
Lifetime Payments are made as long as the annuitant lives. This option pays the highest income per dollar applied because there is no payment obligation at the death of the annuitant. Lifetime with a period certain: If the annuitant dies before a specified number of years has elapsed (10 or 20, for example), payments will continue to the beneficiary for the balance of the specified period. If the annuitant lives beyond the specified period, payments continue until death of the annuitant. Life annuity, joint and survivor: Payments are made for as long as both annuitants are living. The payments may remain at the same level or can be designed so that at death, all subsequent payments to the survivor will be reduced to either two thirds or one half. A period certain may be added to this option.
Payments to Age 100 Payments will be made to the annuitant's 100th birthday. If death occurs prior to that date, payments will continue to the named beneficiary until what would have been the annuitant's 100th birthday.
Examples of Payment Schedules
A Life Only – Straight Life immediate annuity is one which makes periodic payments to an annuitant for the duration of his or her lifetime and then ceases. A 10 C and C - Life with 10 Years Certain immediate annuity guarantees that payments will be made for at least ten years, regardless of whether the annuitant survives over that period. If he/she does not survive, the remainder of the 10-year payments will be made to a beneficiary. If the annuitant survives beyond the 10-year guarantee period, payments will continue for the duration of his/her lifetime and then cease.
A 20 C and C - Life with 20 Years Certain Annuity is administered in the same way as the 10 year C&C annuity, except that the guarantee period covers twenty years instead of ten.
Generally, the tax status of the funds used to buy an annuity directly influences the purchase rates most insurance companies will apply to a deposit. Some insurance companies will pay a different income for the same dollar deposit based on qualified funds. Payments are based upon the age and status of the annuitant. Here is a payment scale for a single 50 year old male:
A Single Life Only, Without Refund: Level payments are received for the annuitant’s lifetime and cease upon the annuitant’s death.
Single Life with 5-Years Certain (5-Years Certain & Continuous): Level payments are received for the annuitant’s lifetime. However, if the annuitant should die before the end of 5 years, payments will be paid to the designated beneficiary until the end of the 5 year period.
Single Life with 10-Years Certain (10-Years Certain & Continuous): Level payments are received for the annuitant’s lifetime. However, if the annuitant should die before the end of 10 years, payments will be paid to the designated beneficiary until the end of the 10 year period.
Single Life with 15-Years Certain (15-Years Certain & Continuous): Level payments are received for the annuitant’s lifetime. However, if the annuitant should die before the end of 15 years, payments will be paid to the designated beneficiary until the end of the 15 year period.
Single Life with 20-Years Certain (20-Years Certain & Continuous): Level payments are received for the annuitant’s lifetime. However, if the annuitant should die before the end of 20 years, payments will be paid to the designated beneficiary until the end of the 20 year period.
Single Life with 25-Years Certain (25-Years Certain & Continuous): Level payments are received for the annuitant’s lifetime. However, if the annuitant should die before the end of 25 years, payments will be paid to the designated beneficiary until the end of the 25 year period.
Single Life with Installment Refund Level payments are received for the annuitant’s lifetime. However, if the annuitant should die before receiving an amount equal to the original premium, the periodic payments will continue to be paid to the designated beneficiary until the total payments made (annuitant and beneficiary) equal the original premium (without interest).
Single Life with Cash Refund Level payments are received for the annuitant’s lifetime. However, if the annuitant should die before receiving an amount equal to the original premium, the difference between the premium and the total payments received will be paid in one lump sum to the designated beneficiary.
Joint-and-Survivor Annuity The fixed monthly income lasts for one’s lifetime and the lifetime of a named beneficiary, such as his spouse. The size of the check depends on what the beneficiary will receive after one’s death.
The list below reports Joint-and-Survivor annuities for a male and a female. Two different forms of the J&50%S annuity are listed. For the first J&50%S form, income reduces by half upon the death of either the primary or secondary annuitant (and continues to the survivor for the remainder of his/her lifetime). With the second type of J&50%S annuity, the level monthly payment is reduced only on the death of the primary annuitant (it does not reduce on the death of the secondary annuitant). This latter form of J&50%S annuity is also known as the ERISA or "QJSA" annuity. Lastly, the rates for the Joint & 100% Survivor Annuity do not reduce regardless of which annuitant dies first and continue in full as long as either annuitant is living.
Joint & Survivor (50%...75%) reducing on first or either death: Full level payments are made as long as both the annuitant and joint annuitant are alive. Upon the death of either the annuitant or joint annuitant, reduced (50%...75%) level payments will continue to the survivor for as long he/she is alive.
Adding a Period Certain provision to a Joint & Survivor (50%...75%) annuity accomplishes the following: Even if the annuitant or joint annuitant dies before the end of the certain period, payments to the survivor will not reduce until after the end of the certain period (5-25 years). If both the annuitant and joint annuitant die before the end of the certain period, full level payments will be paid to the designated beneficiary until the end of the certain period.
Joint & Survivor (50%...75%) reducing only on death of primary annuitant: Full level payments will be made for as long as both the annuitant and contingent annuitant lives. Payments are never
reduced to the primary annuitant. Payments are reduced to the contingent annuitant should the primary annuitant predecease the contingent annuitant. Some companies have a Joint & Survivor or Joint and Contingent type.
Adding an Installment Refund provision to a Joint & Survivor (50%...75%) annuity does the following -- Full level payments will be made for as long as both the annuitant and contingent annuitant lives. Depending on whether the annuity is of the Joint & Survivor or Joint and Contingent type, payments may reduce upon the death of either annuitant or only if the primary annuitant predecease the contingent Annuitant. However, if both the primary annuitant and joint annuitant should die before receiving in periodic payments an amount equal to the original premium, then the periodic payments continue to be paid to the estate or designated beneficiary until the total payments made (to both annuitants while living and to the beneficiary after the annuitants' deaths) equals the original premium (usually, without interest).
Adding a Cash Refund provision to a Joint & Survivor (50%...75%) annuity does the following-- This only difference between this option and the Installment Refund provision is that if both the primary annuitant and joint annuitant should die before receiving in periodic payments an amount equal to the original premium, then the difference between the original premium (usually, without interest) and the periodic payments received during the annuitants' lifetimes, is paid to the estate or designated beneficiary in a single lump sum.
Adding a Period Certain provision to a Joint & Contingent (50%...75) annuity does this: If the annuitant dies before the end of the certain period, payments to the contingent annuitant will not reduce until after the end of the certain period (5-25 years). If both annuitants die before the end of the certain period, full level payments will be paid to the designated beneficiary until the end of the certain period.
Joint & Full Survivor (100%): Level payments are made for as long as either the annuitant or joint annuitant is alive.
Joint & Survivor (100%) with Certain Period: Adding a Period Certain provision to a Joint & 100% Survivor annuity does this: If both the primary annuitant and joint annuitant should die before the end of the specified certain period (5-25 years), full level payments will be paid to the designated beneficiary until the end of the certain period.
Joint & Survivor (100%) with Installment Refund: Adding an Installment Refund provision to a Joint & 100% Survivor annuity does the following -- Level payments are received for the annuitants' lifetimes. However, if both the primary annuitant and joint annuitant should die before receiving in periodic payments an amount equal to the original premium, then the periodic payments continue to be paid to the estate or designated beneficiary until the total payments made (to both annuitants while living and to the beneficiary after the annuitants' deaths) equals the original premium (usually, without interest).
Joint & Survivor (100%) with Cash Refund: Adding a Cash Refund provision to a Joint & 100% Survivor annuity does the following -- Level payments are received for the annuitants' lifetimes. However, if both the primary annuitant and joint annuitant should die before receiving in periodic payments an amount equal to the original premium, then the difference between the original
premium (usually, without interest) and the periodic payments received during the annuitants' lifetimes, is paid to the estate or designated beneficiary in a single lump sum.
Installment Payments The investor signs up for a fixed number of payments-level or rising-over a period of his choice, but not exceeding his life expectancy. He may outlive this income so he will need a source of support to fall back on. If he dies before getting all the money, the remainder goes to his heirs rather than to the insurance company. This is a good alternative to a straight-life annuity.
To determine how much monthly income one will receive for a specific deposit amount, simply multiply the rate factor by the number of thousands of dollars he intends to buy the annuity with. For example, assume the rate factor is $7.00 per thousand and he wants to use $50,000 to purchase an annuity. Multiply the rate factor ($7.00) by the number of thousands of dollars (50). His premium would provide $350.00 of monthly income (50 X $7.00 = $350.00).
Suppose an investor wants to know how much it would cost to buy an annuity that provides $500 of income per month and the annuity form he wants shows a rate factor of $6.50. Take the monthly income (in this case $500) and divide it by the rate factor ($6.50). This will tell him how many thousands of dollars it would cost to purchase that amount of monthly income. Thus, $500 ÷ 6.50 = 76.923 thousands, or $76,923.
Single Payment Deferred This method of purchasing an annuity is 'Single Payment Deferred'. With this type of payment option the investor puts a lump sum into an annuity. The payment begins years later when the annuitant begins his payout. For example, a 30 year old decides to put $20,000 into an annuity. He wants the payout to begin when he is 65 years old. For the next 35 years the $20,000 he put into the annuity builds up earnings. With this payment option, the payout is deferred. And the money that is put into it originally accumulates earnings for the deferral period. This is a good way to begin retirement planning if an individual has a fair amount of money that he or she does not need for immediate use.
Periodic Payment Deferred The third payment option is the 'Periodic Payment Deferred Annuity'. With this type of payment option, the investor puts a specified amount of money into his annuity account periodically over a period of years. However, it is possible to vary the periodic payment amount. Each time the investor puts money into the account the insurance company keeps track of the principal and interest. This method is also a good way to defer paying taxes on earnings. As with all annuities, the tax is deferred on earnings until the payout begins. What makes this even better is that one can choose a form of monthly payout, by only paying taxes on the annual payout. At retirement, most people are in a lower tax bracket.
Accumulation Units The insurance company uses an accounting method called Accumulation Units. A mutual fund, uses Net Asset Value per share to account for its investments. A variable annuity also uses Net Asset Value. Each evening at 4 p.m. Eastern Time when the New York Stock Exchange closes, the separate account portfolio is valued and divided by the total number of accumulation units. This works very similar to a mutual fund valuation. Annuity purchases placed prior to 4 p.m. Eastern Time are
credited to the individual as of that day. An annuity purchases placed after 4 p.m. eastern time are credited to the individual as of 4 p.m. Eastern Time the following day.
When the contract owner retires and begins monthly payouts, the insurance company is going to go through a process called annuitizing. On that day, the insurance company will convert the account into a fixed number of annuity units. Regardless of what happens in the future, the amount of annuity units will remain the same for the rest of the annuitant's life. With a variable annuity, what will change is the value of each annuity unit. So what is important at this point is not the amount of annuity units, but rather the value of each annuity unit. The value of each annuity unit will fluctuate. And it is the value of each annuity unit which determines how much will be received each month in the monthly payout. To figure out exactly how much is in an annuity after payout begins, the contract owner can multiply the annuity units by the net asset value. Also, some annuity contracts call for the annuity payout to be changed monthly, some call for quarterly changes, some call for semi-annual changes, some call for annual changes. Payout will come in the form of annuity units.
Surrender Charges The actual length of the surrender charges are vital in planning out the time frame in which one may desire to start receiving his benefits without penalties. An individual whose age is presently 55, and who would like to retire and start collecting the annuity benefits at 62, would maximize earnings and at the same time avoid any penalties by selecting a 7 year annuity. However, if this same individual purchased an annuity that had a 12 year surrender period, he would incur a significant surrender charge.
Equity-Indexed Annuities Equity-indexed annuities are one of the hottest insurance products going these days. In the last few years, total sales have jumped from an estimated $5 billion to between $20 billion and $30 billion. Not bad for a product that didn't exist a few years ago. Annuities have long been seen as a prudent way to earn a comfortable return on the contract owner’s money while deferring the taxes on gains. Fixed annuities offer a specified and company-guaranteed return, but the contract owner pays for that guarantee in the form of modest returns because fixed annuities invest one’s premiums in interest-bearing obligations. These obligations have interest rates that have historically trailed stock-market returns. Variable annuities let the contract owner place funds in any number of investment-grade securities and, therefore, offer better returns, but also offer higher risk.
Equity-indexed annuities, or EIAs for short, offer consumers what could be described as the best of both worlds: a market-driven investment with attractive returns, plus a guaranteed minimum return. Brokers and agents like EIAs for another quite practical reason: because EIA returns are tied to indexes of market activity and not to the performance of individual stocks or funds, they have not been considered an investment product subject to U.S. Securities and Exchange Commission oversight. Therefore, while variable annuity products must be registered with the SEC, must issue prospectuses, and can only be sold by professionals with securities licenses, EIAs are not federally regulated and brokers don't need a securities license to sell them.
But just what are equity-indexed annuities? And are they really the best thing since sliced bread? And why do some financial experts call them the worst of both worlds? Just understanding the equity-indexed annuities market is a daunting task. "If you’ve seen one equity-indexed annuity, you've seen one," an actuary said recently. "They're all different."
Equity-indexed annuities guarantee customers a minimum interest rate (often about 3 percent) while offering the potential of higher rates by tying the return to an index like the Standard and Poor's 500. While it's a lot like investing directly in the stock market, customers don't get the full boost of a rising market. With equity-indexed annuities, the money put down by purchasers is not invested directly in the stock market. Instead, customers are offered a percentage of how much the index gains over a period of time (not including dividends, which accounted for about 30 percent of the total return of the S&P 500 for the last 20 years), and a guaranteed minimum return if the stock market declines. At predetermined times during the annuity's life; customers are credited with a percentage of the gain of the index. The schedule varies with each annuity. Some offer annual "indexing," while others use various averages taken over the life of the annuity.
Indexing Methods There are five main indexing methods, each with its own variations and benefits:
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The European Method This “point to point” method divides the index on the maturity date by the index on the issue date and subtracts 1 from the result. Other indexing methods use this same formula, with different data points. This ignores all the fluctuations between start and finish, and makes this method the simplest both to understand and to calculate. One drawback is that market fluctuations can produce very different results for customers who bought the policy just a few days apart. The method's name comes from European stock markets, where options can only be exercised on their expiration date.
The Asian Method This method involves averaging several points of the index to establish the beginning and/or ending index. This method can help shield consumers from the risk of a market decline on the maturity date. Some companies take an average of the twelve monthly indices to establish the policy's maturity index level. This method takes its name from the Asian stock markets.
The High-Water-Mark Method This is another popular approach. On each policy anniversary, the company notes the index level. The highest of these is then taken and figured as the index level on the maturity date.
The Low-Water-Mark Method This method uses the lowest of the indices on each of the policy anniversaries before maturity as the level of the index at issue. This method tends to lessen the risk of market decline.
The Annual Reset (Cliquet or Ratchet) Method This method is among the most complicated. The increase in the index is calculated each policy year by comparing the indices on the beginning and ending anniversaries. Any resulting decreases are ignored. Appreciation is figured by adding or compounding the increases for each policy year.
Most equity-indexed annuities offer participation rates between 70 and 90 percent, and some place a cap on how much one can gain. If the product has a 14 percent cap, and the market gains 34 percent, one is stuck with 14 percent. For example if an individual invests $5,000 for an equity-indexed annuity with an 80 percent participation rate and a 14 percent cap and the S&P 500 goes up 15 percent, he or she will gain $600. If someone invested $5,000 directly in the stock market, he or she would have gained $750.
Guaranteed Return While it would seem investing in the stock market might be a better option, it's also riskier. Equity-indexed annuities are designed to offer a safety net -- that guaranteed minimum return. Most companies offer a guaranteed minimum return of at least 3 percent, but sometimes that's not on the entire sum one can put down. More often, the company guarantees that he or she gets at least 3 percent of 90 percent of a deposit. If the stock market takes a dive, money could be lost.
Even if the guaranteed return is based on the entire deposit, one might just wind up breaking even. Over the last few years, inflation has averaged about 3 percent. If an individual earned 3 percent each year on a deposit of $5,000, he or she will have $6,149.37 after seven years (a typical term for an annuity). But if inflation keeps steady at 3 percent in those same seven years, the $6,149.37 will be worth the same as the $5,000 that same individual put down in the first place. Equity-indexed annuities are not currently regulated by the federal Securities and Exchange Commission. But that
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could change. The SEC is seeking comment on whether the products should be categorized as insurance, a security, or both.
Insurance companies are required to file their equity-indexed annuities with each state, where they are regulated. Since equity-indexed annuities have been around for a relatively short time, regulating them can be tricky. With several different models for equity-indexed annuities, each with its own benefits and disadvantages, developing a regulatory model that covers all the bases for consumers won't be that easy for the states. But that doesn't mean they won't try.
According to one official at Connecticut's Department of Insurance, the recent problems with "vanishing premium" life insurance policies have insurance regulators across the country wanting to stay ahead of the game. Trying to develop regulations requiring uniform illustrations of equity-indexed annuities may be the biggest hurdle for the states. Insurance companies use illustrations (usually several graphs, replete with footnotes) to show potential customers how a product will likely perform. Many insurance companies have come under fire in recent years for their illustrations. The National Association of Insurance Commissioners, a group of state insurance officials, is considering whether to develop model illustrations to help consumers considering the purchase of equity-indexed annuities.
Insurance companies cover their costs for equity-indexed annuities by investing the premiums they collect. Companies typically buy coupon bonds to cover the guaranteed minimum return, and call options to cover market appreciation. It's a delicate balance -- one which doesn't offer the company any guarantee it'll make any money. Companies often use interest-rate caps to cover their bases.
How good an investment are equity-indexed annuities? It may be too soon to tell. Since equity-indexed annuities have only been on the market about two years, it's a little difficult to get a handle on Long-term performance. In order to get in the door with an equity-indexed annuity, one has to plunk down a hefty sum -- typically at least $5,000 -- and will have to leave it with the insurance company for anywhere between five and 10 years. Most equity-indexed annuities allow the owner to take money out, but he or she will be charged for that privilege. Besides, if the owner takes money out of any annuity before age 59 1/2, he or she will probably have to pay a tax penalty. And if one wants to get out of an equity-indexed annuity before it matures, he or she has to pay a "surrender charge." The surrender charges often decrease the longer one lets the insurance company keep the money.
Single Premium Retirement Annuity (SPRA2) This annuity helps save for retirement on a tax-deferred basis. If one is worried about saving enough for retirement, this product may help to realize retirement goals. Single Premium Retirement Annuity is a competitive deferred annuity designed to satisfy retirement needs. Even if an individual has not reached retirement, the time to begin shaping a financial future is now. A deferred annuity could provide the money needed, down the road. A deferred annuity could provide a very good solution to many situations in an individual’s life such as a savings alternative that can take care of financial needs and perhaps even provide a legacy for children or grandchildren.
• SPRA-2 allows money to grow tax-deferred at competitive interest rates.
• SPRA-2's liberal withdrawal provisions offer the flexibility to control financial situations.
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• SPRA-2’s allow an individual to use the money that has accumulated to generate a retirement income that he or she cannot outlive.
The Single Premium Retirement Annuity helps ensure that an individual will not outlive a retirement savings. With SPRA-2, one can get more mileage out of money that's currently sitting in a CD or other currently-taxable investment. Or it can be used to consolidate several smaller IRAs. However, emergencies do arise, so SPRA-2 has a 10% "window" that allows someone to take up to 10% of money, each year, without any surrender charges. And after eight years, one can take out as much money as is needed, at any time, without any surrender charges.
Flexibility and Control Unlike many financial products, SPRA-2 offers flexibility and control over when income is received - and when taxes are paid on it. An individual can wait until he or she is retired and in a lower tax bracket before beginning to withdraw money. An individual can also spread withdrawals over several years, to even out the tax burden and avoid throwing oneself into a higher tax bracket or increasing the taxation of Social Security benefits.
Guaranteed Death Benefit If one dies prematurely, the total accumulation value of the policy is paid directly to the named beneficiary (ies), avoiding the costs and delays of probate. These funds could provide much-needed comfort to beneficiaries during a stressful time, when other monies may be unavailable to them. If a spouse is the primary beneficiary, he or she even has the option of becoming the new owner of the annuity, and continuing to build money, tax-deferred.
Single Premium Immediate Annuity (SPIA) People are living longer and longer these days, but they haven't always made sure that they have the financial resources for an extended lifetime. SPIA is a product that can take away these worries. SPIA gives more security than a typical savings account, which one can continuously draw upon, hoping it will last an entire lifetime. SPIA does not have an account value one can access, but the income received from the insurance company is guaranteed never to run out. That's something a savings account cannot offer. And SPIA also offers alternatives that can provide a lifetime income for both the contract owner and his or her spouse or provide income to loved ones if the contract owner dies prematurely. The SPIA income is a fixed amount of money based on the age, the gender, the amount of premium payment, and the frequency with which one receives income payments: monthly, quarterly, semi-annually, or annually.
Safe from Market Fluctuations In addition to providing a guaranteed lifetime income, SPIA can also take away some of the worry about managing money. Unlike income from stocks and bonds, the SPIA payments will not be affected by market swings.
Tax-Qualified Money If one has money tucked away in tax-qualified plans, such as an IRA or 401(k) plan, that money will become taxable once it is received. Not only could that extra money throw an individual into a higher tax bracket, it could even be subjected to 85% of Social Security benefits for taxation. Furthermore, if one places tax-qualified money in SPIA, he or she might not have to worry about how to satisfy the Internal Revenue Services' Required Minimum Distribution (RMD) requirements -
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because the SPIA could automatically satisfy them. This is important, because the IRS imposes severe penalties if these requirements are not met. An individual can receive the highest income for premium amount, gender, and age if he or she selects "life only" SPIA.
It guarantees that the insurer will pay the policy owner regularly for the rest of his or her life. Upon death, payments will cease. Sometimes, income for one life is not enough. Many couples want to make sure that they have enough income to last for both of their lifetimes. If one selects a Joint & Survivor SPIA, he or she will receive payments for as long as either one is alive. This way, both policy owner and his or her spouse will be protected against outliving the savings amassed together. None of us like to think that if we were to die shortly after giving a lot of money to an insurance company, that money would be completely lost. An insurance company will generally offer alternatives to prevent this.
Guaranteed Period Certain SPIA With this SPIA, one can choose a minimum period of time during which he or she will receive payments: either 5, 10, 15, or 20 years from the date that an individual purchased his or her SPIA policy. If he or she dies before this guaranteed number of years has passed, the insured will continue sending payments to a chosen beneficiary (ies) for the duration of the guarantee period.
Guaranteed Total Amount SPIA If the policy owner dies before the total money received equals the amount of the original premium payment, the insurer will continue to pay the chosen beneficiary (ies) until the total amount paid to an individual and his or her beneficiaries matches the initial premium. So everyone gets what they have paid in. These alternative SPIAs can also help ease the burden on beneficiaries if the policy owner dies before all of the guaranteed payments have been made. Payments go directly to the beneficiaries, unlike many other assets that may get tied up in probate. The SPIA payments could be helpful to beneficiaries at a very difficult time.
Single Premium Fixed Annuity The Single Premium Fixed Annuity offers a tax-deferred growth where the money accumulates without taxation and may grow faster than in a comparable, currently-taxable investment.
• It offers competitive, banded interest rates - one can earn a base interest rate that historically has been higher than average one-year CD rates.
• It gives 1% first-year additional interest rate and generous access to money.
• Withdrawals prior to age 59 ½ may be subject to a 10% IRS penalty.
• The owner has control over finances because he decides when to receive the money and pay taxes on the earnings.
• It offers a guaranteed death benefit without the costs and delays of probate, if payable to the beneficiary.
The SPFA gives the opportunity to generate a guaranteed lifetime income. The initial interest rate will be determined by the amount of premium payment and when the insurer receives it.
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Interest Rates During the first year one will receive an extra 1% over the current base interest rate. (This 1% first-year additional interest rate only applies to policies with a one-year initial interest rate guarantee period issued to individuals prior to age 86.) One can choose either a one-year or three-year initial interest rate guarantee period. After the initial interest rate guarantee period, the policy will receive a new interest rate on each subsequent policy anniversary, and that rate is guaranteed for one year. Money will earn the rate according to amount that the insurer is crediting for premium payments on the date we receive payment.
Principal Guarantee The Principal is guaranteed because upon full surrender of the policy within the first three years, the insurer guarantees that the contract owner will receive an amount equal to at least the premium paid. However, the principal guarantee does not apply if one makes any partial withdrawals. Withdrawals give the contract owner immediate access to the money. There is no limit to the number of withdrawals made each year. Withdrawals may generate a tax liability on amounts not previously taxed and that withdrawals prior to age 591/2 may be subject to a 10% IRS penalty.) All withdrawal requests must be for at least $100. The cash value may not fall below $2,000 due to a partial withdrawal.
Periodic Partial Withdrawals (PPW) An individual may decide that he or she wants to receive payments from a policy on a regular basis (monthly, quarterly, semi-annually, or annually). With a Single Premium Fixed Annuity, the contract owner can choose to receive scheduled payments of the interest earned according to the 10% Window, or any other specified amount, but each payment must be at least $100. The 10% Window allows the individual to make withdrawals from the policy during the surrender charge period and avoid surrender charges.
During the first six years of the policy, up to 10% of the policy's cash value on the preceding anniversary may be withdrawn each year without incurring any surrender charges. At any time during the policy year, the 10% Window equals 10% of the policy's cash value on the preceding policy anniversary less any prior surrender charge-free withdrawals taken during that policy year. After six years, the full cash value is available at any time without any surrender charges. If the payment is $100,000 or more, the contract owner may withdraw, (without incurring surrender charges), the greater of the gain in the policy, known as the Gain Window, or the 10% Window. The Gain Window is the portion of the accumulation value, as of the previous anniversary, that exceeds the payment made to the policy.
Variable Annuities All variable annuities have certain predetermined investment objectives, as well as various restrictions set by the portfolio managers. As an investor, one has the choice of which annuity portfolio, out of over 1,500 available annuities, to invest in, and based on the requirements, how much money to invest. Investors are always looking for the optimum results for their investments as the future of their families' financial well-being is at stake. In order to choose the proper investment vehicle and annuity to invest in, the individual investor must analyze the marketplace based on, but not limited to the following: Existing portfolio, Investment time line, Family and individual goals, Tax bracket, Level of acceptable risk.
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A variable annuity is an investment company, or other official entity, that analyzes and makes investments on behalf of individuals and organizations who have selected specific areas and goals to invest in. The company will pool together money received by all the investors to invest in a particular portfolio or sub account. Investments can be as little as $10 or as high as $10,000, all depending on the specific requirements of each portfolio sub account. The portfolio managers selected to oversee the funds use the money that has been pooled from the investors to purchase various investments such as stocks, bonds, and commodities that, in their opinion, will help the investors meet their individual and collective financial objectives. No matter what the level of investment held by an investor in an annuity, all investors will receive the same percentage yield or return from the sub-account.
The investment strategies and objectives of each individual portfolio and, as illustrated and explained in each individual prospectus, create the philosophy in which investments are made. The fund manager uses it to steer his investments in the right direction, and the investor utilizes it to choose the right vehicle for his investments and personal financial goals. The prospectus will also give detailed information on the specific funds restrictions as well as all costs and expenses connected to the investment.
When a fund earns money, the dividends are reinvested in the fund for the account of the investor, unless otherwise requested, and is reflected as an increased value per unit. Variable annuities have become a very popular investment vehicle as they give any individual the opportunity to access a diverse element of investment opportunities. Annuity investments also allow an individual to invest in foreign based stock and bond markets as the ease of investing in international annuities allows easy entry into the varied international markets.
A variable annuity fund is owned by all of the investors who purchased units in the fund. The annuity's day to day operation is overseen by a management company, who is often an outside mutual fund group and who may offer other financial products and services as well as insurance. The manager of the fund is paid an average of 0.75% for their services and decides where to invest the funds assets. The fund managers make all of their investment decisions based on comprehensive and continual research into the operational and financial performance of select companies within their sphere of interest. On the basis of the information gathered, the fund managers decide what companies to buy, when to buy them, when to sell, and which investments to hold for long term equity. The variable annuity company may also employ an outside underwriter who will package and offer units of a particular fund to the general public.
Investing In a Variable Annuity The investment in a variable annuity is defined by the purchase of units or shares in one or more sub- accounts of a particular investment annuity. By virtue of the size of the investment, a contract owner will become the owner of a set number of units in the annuity chosen. The actual price of the units in any given sub-account is directly related to the value of the securities held by that specific investment account.
All sub-accounts of the offered variable annuities continually issue new shares for purchase by the general investing public. Existing holdings do not decrease because of the continual offering of new units as each unit that is created and sold is offset by the amount of new money received into the fund. The sub-account’s unit price may change from day to day depending on the activity and daily
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value of the securities held by the portfolio of that specific fund. Unit prices are calculated as follows: total value of the sub account's investments at the end of the day by the number of units outstanding.
Unlike stocks, bonds, and mutual funds that are widely reported and listed in most newspapers and publications, the only major paper to list the values of the variable annuities on a weekly basis is Barron's. In listing the different annuity funds, the first line of the heading identifies the insurance company that is making the particular annuity offering, and the second line is the name of the actual variable annuity and usually identifies who is managing that particular sub-account.
An important question to ask about a variable annuity is how long it will take before the tax-deferred growth begins to outweigh one’s additional expenses, making him better off with the annuity than with a regular fund. The following factors would lead to a shorter break-even time: lower costs, a higher tax bracket, and higher investment returns.
The latter factor is an important consideration--aggressive growth, growth and income, and international stock portfolios would tend to provide an investor with greater returns than fixed-income funds, so it makes less sense to buy a variable annuity if one does not want to invest in these kinds of portfolios. The variable annuity is where the most aggressive part of one’s portfolio should be, provided he can tolerate a risky component.
Because of the higher costs associated with annuities, one should first invest as much as he can in regular retirement plans, such as the 401(k), IRA, and Keogh. If he still has money to put away on a tax-sheltered basis, he can start thinking about a variable annuity. Obviously, he wouldn't want to hold a variable annuity in an IRA account, just as he wouldn't want a tax-exempt bond fund put into an IRA. This would be placing one tax shelter into another, which would be a major mistake.
Variable annuities offer a brief examination period during which one can change his mind if the contract doesn't suit him. If disappointed, he can exit after a few days without any penalty.
Advantage and Disadvantage of Variable Annuities The outstanding advantage is higher long-term return on average. Since the end of World War II, equity based investments have outperformed debt based investments (bonds) for long-term investors. Assuming this historical data holds true into the future, a variable annuity held for a number of years can outperform a conventional deferred annuity, on average. The negative rates of return are the greatest disadvantage. Unlike fixed annuities that guarantee a minimum rate of return, variable annuity returns can be negative in any given year.
Fair Rate of Crediting With variable annuities, what separate accounts earn -- less a predetermined insurance company fee -- determines what return is credited to the annuity. This is in contrast to a regular annuity, for which an insurance company arbitrarily credits the account, a subjective rate of interest which they determine is "appropriate". This issue of appropriate interest crediting is frequently abused by unscrupulous carriers in the deferred annuity market. These carriers lure investors in with high first-year rates (and higher surrender penalties) and credit very low rates on renewal. Because of the high surrender penalties, the annuitant is forced to accept these low renewal rates, or forfeit a large percentage of their principal. Variable annuity accounts may have good years and bad years, but at least one knows how the return will be determined.
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Deferred Taxes on Policy Gains Like all annuities, a variable annuity's gains are deferred until proceeds are withdrawn. At this point they will be taxed as ordinary income, but the principal (original investment) will be returned tax free.
Ordinary Income Tax vs. Capital Gains Tax When earnings are withdrawn from a variable annuity, they are taxed as ordinary income. For investors in the top income tax brackets, this rate could exceed the current capital gains rate. Variable annuities have a higher expense load than their non-variable counterparts. Much of this expense is associated with administering the separate equity accounts and paying transaction costs. Because of the higher potential return equity accounts offer, this expense may be overcome through time. If someone is considering buying a variable annuity and then creating a bond based portfolio, he or she probably would be better off buying a traditional annuity and avoiding the extra expense of a variable product.
Costs Associated with a Variable Annuity Surrender Charge Most variable annuities have back-end surrender charges, similar to a contingent-deferred sales charge on a regular mutual fund; front-end loads are rare. A typical charge might be 7% in the first year, 6% in the second, 5% in the third, and so on, phasing out completely after seven years. Surrender charges may kick in again, however, under certain conditions--if you make additional investments, for example.
Maintenance Fee The annual contract maintenance fee generally ranges from $25 to $40.
Fund Operating Expenses These costs include the portfolio management fees and other expenses you would have with an ordinary mutual fund, expressed as a percentage of net assets.
Insurance-Related Charges These include "mortality and expense-risk charge." They can range from 0.5% to 1.75% a year of average account value. This is the fee for the guaranteed death benefit and covers a longer "lifetime" payout period should the annuitant, or joint annuitant, outlive normal life expectancy. In addition, it covers a guarantee by the insurance company that your expenses will never exceed a specified amount. There is also an administrative fee under this category.
Variable Annuity Prospectus The prospectus is prepared to give the potential investor as much information as may be necessary to make a concise and knowledgeable investment decision and must offer the reader a full and complete disclosure of everything to do with the offered annuity. The following is typical of a Table of Contents that would be a part of any prospectus.
Expense Table - This lists all costs that are to be incurred by the contract holder/investor, including any and all contingent deferred sales charges plus the annual contract fee charged mortality risks, expense fees, and management fees.
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Synopsis - This is a regular feature that gives commonly asked questions and their appropriate answers.
Condensed Financial Information - This explains in detail how each of the annuity's sub-accounts have performed over each of the past several years.
Investment Results - This is a company policy statement that explains how sales figures have been determined and properly evaluated.
Financial Statements - This is the section that gives detailed financial information pertaining to the insurer.
The Insurance Company - This gives all pertinent information on the insurance company issuing the annuity contract.
Variable Account - This section details how the annuity investment was formed and which SEC and other agency rules and regulations apply to the continued operation of it.
Investments of the Variable Account - This will describe the investment advisor, management, and the different sub accounts that will be made available to the investor.
Charges and Deductions - This gives information pertaining to the annual maintenance and administrative charges, up front charges, mortality and expense charges, and deductions for any state or federal premium taxes.
The Contracts - This illustrates how to go about making an investment into the annuity and how all valuations, transfers, reinvestments, ownership's and death benefits are determined.
Annuity Payments - This section analyzes and describes all the payment options that will be made available to the investor.
Federal Tax Status - This is a general statement that the annuity contracts do not pay current income taxes (deferred growth) but that there are IRS penalties and costs involved if money is withdrawn prior to age 591/2, unless: death or disability occurs, distributions are equally made as a life annuity, there is a structured settlement, the annuity is annuitized, or the investment was part of a certain type of retirement plan.
Voting Rights - States how many votes per share the investor will receive and under what conditions voting will take place.
Contract Distribution - How the investment is sold and distributed.
Return Privilege - All annuities have an initial period in which the investor can make an actual investment but for whatever reason can return the investment within an identified time period. The investment is still at risk due to market fluctuations during this time.
State Regulation - This identifies in what state the insurance company is licensed to do business in and under what laws it is governed.
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Records and Reports - This details how, when, and to where the issuer is to send periodic records and reports to the individual investors in the annuities.
Legal Proceedings - This section will detail any legal proceedings, if any, against the insurance company.
Deferred Annuities A tax-deferred annuity offers the same benefits as a non-deductible IRA but without the $4,000 contribution limit (2005), the mandatory withdrawal requirement at age 70 1/2, and without all the record keeping and reporting requirements. A buyer has 3 methods of obtaining funds from an annuity: Partial Withdrawal: Subject to contract fees and charges; Complete Withdrawal: Subject to contract fees and charges; Periodic Payments: Normally for life upon annuitization of the contract, which usually occurs at retirement.
Fixed Deferred Annuities Fixed annuities are viewed as secure investments by many people, since the insurance company that offers the annuity guarantees the current cash value plus a future guaranteed interest rate. Today, they often offer interest rates that are comparable to (or higher than) CDs, along with the added benefit of deferring taxes on the earnings until they are withdrawn. Unlike annuities, CDs are FDIC insured. Fixed annuities, unlike many other fixed interest investments, contain guarantees of minimum future interest rates. All fixed annuities have a minimum rate guarantee that specifies the lowest rate the insurer can offer. Some contracts also offer a "bailout" provision that allows the owner to withdraw money from the annuity without surrender charges if the crediting rate falls by more than a specific amount.
Variable Deferred Annuities Variable deferred annuities are often said to combine the best advantages of mutual funds with the tax-deferred growth of an annuity. These annuities usually offer a choice of several types of investments that purchase shares of stock, bond, money market, and specialty funds. The owner may select how to allocate the policy's cash value and is able to transfer money among these investment options. A variable annuity may offer investors opportunities for higher potential growth than is usually available with a fixed interest investment. For investors who seek the professional fund management and asset diversification that is available with a mutual fund, but who prefer always to defer immediate income tax on their gains, a variable annuity may be the perfect solution. An unusual feature found only in variable annuities is the guaranteed death benefit. The value of a variable annuity death benefit is guaranteed never to be less than the total of the premiums paid, less any withdrawals that have occurred.
Flexible Premium Fixed Annuity The Flexible Premium Fixed Annuity offers the ability to begin saving for the future - the low initial premium requirements allow individuals just starting out to begin saving for retirement. Tax-deferred growth means that money accumulates without taxation and may grow faster than in a comparable investment that can be taxed currently. Competitive interest rates earn a base interest rate that historically has been higher than average one-year CD rates.
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Interest Crediting Interest rate for the initial premium will be guaranteed for one year. A new rate will be declared on each policy anniversary. On the first policy anniversary, the annuity will earn an additional payment of 1% for all premium payments made during the first policy year. The interest rate is set quarterly. All payments that are received during a calendar quarter will receive the rate in effect at the time the payment is received. The rate is guaranteed until the end of the policy year. The interest rate will never be less than 3%. Money will earn the rate being credited for payments on the date that the insurer receives payment.
Additional Payments The contract owner may add money to a Flexible Premium Fixed Annuity policy at any time. Any additional payments must be at least $50 and are limited to a total of $50,000 per policy year. The additional payments will receive the crediting rate in effect at the time the payments are received. The interest rate will remain in effect until the policy anniversary. At that time, all of the money in the policy (including additional payments and interest earned) will be combined, and one interest rate will apply to the total cash value of the policy for the next policy year.
Withdrawals The contract holder has immediate access to the money in the Flexible Premium Fixed Annuity policy through partial withdrawal options. There is no limit to the number of withdrawals that the contract owner is able to make each year. Withdrawals may generate a tax liability on any amount not previously taxed, and that withdrawals prior to age 59 1/2 may be subject to a 10% IRS penalty. All withdrawal requests must be for at least $100. The cash value may not fall below $2,000 due to a partial withdrawal.
Periodic Partial Withdrawals (PPW) A contract owner may decide that he or she wants to receive payments from a policy on a regular basis (monthly, quarterly, semi-annually, or annually). With a Flexible Premium Fixed Annuity, he or she can choose to receive scheduled payments of the interest earned
10% Window Withdrawals can be made from the policy during the surrender charge period and avoid surrender charges. These withdrawals can be made during the first nine years of the policy, up to 10% of your policy's cash value on the preceding anniversary may be withdrawn each year without incurring any surrender charges. Or they can be made at any time during the policy year as the 10% Window equals 10% of the policy's cash value on the preceding policy anniversary less any prior surrender charge-free withdrawals taken during that policy year. The last option for making withdrawals is after nine years when the full cash value is available at any time without any surrender charges.
Gain Window If the total accumulated payments are $100,000 or more, the contract holder may withdraw without incurring surrender charges the greater of the gain in the policy, known as the Gain Window, or the 10% Window. The Gain Window is the portion of the accumulation value, as of the previous anniversary, that exceeds the total payments made to the policy, as of the previous anniversary. For tax-qualified annuity policies, the IRS generally requires that all policy owners begin receiving payments from their policies the year in which they reach age 70 1/2, or, if later, the year in which
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they retire. These payments are called Required Minimum Distributions (RMDs). Policy owners who fail to withdraw their RMD amounts may be subject to IRS penalties.
With the Flexible Premium Fixed Annuity, the amount of the RMD payments will be automatically calculated. If the contract owner selects this option, he or she will not incur surrender charges for withdrawing the RMD amount, even if it is greater than the 10% Window. RMDs can be received on a monthly, quarterly, semi-annual or annual basis. RMD withdrawals will count toward the 10% Window for any previous or future withdrawals. Periodic partial withdrawals and automated RMD cannot be used concurrently.
Combination Annuity There is an alternative to the either/or of variable and fixed annuities. It is part-fixed and part-variable. This type of annuity will allow for the individual to receive part of his annuity in a fixed manner and part of it will be variable. The benefit of this type of annuity is that it takes some of the uncertainty out of having only a variable annuity. The percent in each part of the annuity can be set to each individuals needs. It doesn't have to be 50/50. It could be 75/25 or any other combination the annuitant feels comfortable with. One of the other benefits of this type of annuity is that it will protect the investor from a disinflation period.
Tax Favored Annuities A tax-favored annuity is a long-term retirement plan that provides a systematic, tax-sheltered way to accumulate funds for retirement. If one works for a school or other qualifying tax-exempt organization covered under IRC Section 501(c)(3) he or she can accumulate money for retirement in a special tax-sheltered plan - a 403(b) Tax-Favored Annuity. A tax-favored annuity reduces current taxable income. Tax favored annuity contributions are excluded from current taxable income and are tax-deferred until the contract owner begins to receive distributions from the annuity. Interest earned on the annuity contribution is tax-deferred until one begins to receive distributions. A tax-favored annuity offers a high degree of financial security. Tax-favored annuities are commonly offered in the form of fixed annuities. These are guaranteed to earn no less than a guaranteed minimum interest rate stated in the annuity contract. The fixed annuities are backed by the general account of the insurance company. A tax-favored annuity does not reduce other retirement benefits.
Immediate Annuities With an immediate annuity, the annuitant pays an insurance company a certain amount of money as a premium. In return for this premium, the insurance company promises to pay a specified amount to the annuitant (or his or her beneficiary) for a specified period. With an immediate annuity, a 60-year old annuitant may pay a $100,000 premium to an insurance company. After considering the annuitant's age and gender the company will then guarantee to pay the purchaser some fixed fee per year for as long as he or she lives (or a certain period of time). A portion of this payment is considered a return of premium and therefore not taxable to the annuitant. The remainder is considered interest and will be taxable as such. One of the advantages of an immediate annuity is that an annuitant cannot outlive his or her guaranteed payments. While deferred annuities are designed to help maximize savings, immediate annuities are there to make sure savings provide an income for as long as is needed. Immediate annuities, as the name implies, begin paying an
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immediate income and last for a specific time-period that the contract owner selects. They are often designed to pay as long as one lives. These annuities are commonly used to provide pension benefits to retired employees. Qualified The term “qualified” when applied to immediate annuities refers to the tax status of the source of funds used for purchasing the annuity. These are premium dollars which until now have "qualified" for IRS exemption from income taxes. The whole payment received each month from a qualified annuity is taxable as income since income taxes have not yet been paid on these funds. Qualified annuities may either come from corporate-sponsored retirement plans (such as Defined Benefit or Defined Contribution Plans), Lump Sum distributions from such retirement plans, or from such individual retirement arrangements as IRAs, SEPs, and Section 403(b) tax-sheltered annuities, or Section 1035 annuity or life insurance exchanges. Generally speaking, insurance companies use male/female (sex-distinct) rates to price qualified annuities in situations where the purchaser and/or owner is a corporation. When the annuity is being purchased by an individual, annuity rates are generally unisex. Some states, however, require that unisex rates be used for all qualified annuities.
Non-Qualified Non-qualified immediate annuities are purchased with monies which have not enjoyed any tax-sheltered status and for which taxes have already been paid. A part of each monthly payment is considered a return of previously taxed principal and therefore excluded from taxation. The amount excluded from taxes is calculated by an Exclusion Ratio, which appears on most annuity quotation sheets. Non-qualified annuities may be purchased by employers for situations such as deferred compensation or supplemental income programs, or by individuals investing their after-tax savings accounts or money market accounts, CD’s, proceeds from the sale of a house, business, mutual funds, other investments, or from an inheritance or proceeds from a life insurance settlement. While most insurance companies apply their male/female (sex-distinct) tables to non-qualified annuities, some states require the use of unisex rates for both males and females.
Generally, the tax status of the funds used to buy an annuity directly influences the purchase rates most insurance companies will apply to a deposit. For Period Certain Annuities, however, rates are not affected by whether the funds are non-qualified or qualified. In addition, the age and sex of the annuitant have no bearing on the rates of period certain annuities.
To determine how much monthly income one will receive for a specific deposit amount, simply multiply the rate factor by the number of thousands of dollars he intends to buy the annuity with. For example, assume the rate factor is $8.00 per thousand and he wants to use $50,000 to purchase an annuity. If he multiplies the rate factor ($8.00) by the number of thousands of dollars (50), his premium would provide $400.00 of monthly income (50 X $8.00 = $400.00).
By doing a slightly different calculation, he can also use the rate factor to determine how much it would cost to purchase a specific level of income. For example, suppose he wants to know how much it would cost to buy an annuity that provides $500 of income per month and the annuity form he wants shows a rate factor of $8.00. Simply take the monthly income (in this case $500) and divide it by the rate factor ($8.00). This will tell him how many thousands of dollars it would cost to purchase that amount of monthly income. Thus, $500 ÷ 8.00 = 62.5 thousands, or $62,500.
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Stable Income The benefit of an immediate annuity is the consistent and stable income it provides. The contract owner knows that a check for a specific amount will be received on a regular basis and that the income will continue for as long as he or she has requested. The contract owner can even arrange for an annuity to pay for as long as he or she lives or until the spouse lives. This last option is called a Joint and Survivor Immediate Annuity.
Period Certain Annuities 5-Years Period Certain Without Life Contingency: Level payments are received for 5 years. If the annuitant should die before the end of the certain period, payments will be paid to the designated beneficiary. No payments are made to the annuitant after the end of the specified period. One may outlive this type of annuity.
10-Years Period Certain Without Life Contingency Level payments are received for 10 years. If the annuitant should die before the end of the certain period, payments will be paid to the designated beneficiary. No payments are made to the annuitant after the end of the specified period. One may outlive this type of annuity.
15-Years Period Certain Without Life Contingency Level payments are received for 15 years. If the annuitant should die before the end of the certain period, payments will be paid to the designated beneficiary. No payments are made to the annuitant after the end of the specified period. One may outlive this type of annuity.
20-Years Period Certain Without Life Contingency: Level payments are received for 20 years. If the annuitant should die before the end of the certain period, payments will be paid to the designated beneficiary. No payments are made to the annuitant after the end of the specified period. One may outlive this type of annuity.
CHAPTER FIVE FFEEAATTUURREESS AANNDD BBEENNEEFFIITTSS OOFF AANNNNUUIITTIIEESS
Some of the benefits of annuities are:
• The earnings on the contributions accumulate tax deferred until the owner receives payments.
• The money is invested in a professionally managed portfolio with professionals who should be able to obtain a better return on money than a person can as an individual.
• The annuitant can terminate (surrender) the annuity any time he or she wants (taxes will have to be paid at that time on the earnings).
• The annuitant can choose the age at which the payout will begin.
• There are several good options for paying into the annuity.
• There are several good options for receiving the settlement of the annuity.
Required Minimum Distribution (RMD) Option For tax-qualified annuity policies, the IRS generally requires that all policy owners begin receiving payments from their policies the year in which they reach age 70 1/2, or, if later, the year in which they retire. These payments are called Required Minimum Distributions (RMDs). Contract owners who fail to withdraw their RMD amounts may be subject to IRS penalties. With the single premium fixed annuity, the insurer will automatically calculate the amount of the RMD payments. If an individual selects this option, he or she will not incur surrender charges for withdrawing the RMD amount, even if it is greater than the 10% Window. RMDs can be received on a monthly, quarterly, semi-annual or annual basis. RMD withdrawals will count toward the 10% window for any previous or future withdrawals. Periodic partial withdrawals and automated RMD cannot be used concurrently.
Withdrawal Feature Most annuities allow withdrawals of up to 10% per year without cost, fee, or penalty. The free withdrawal is usually based on a percentage of the principal, not current value. Thus, if Susan Wright invests $50,000 in an annuity, she can withdraw $5,000 each year, after the first year, without any cost. This is true even though her account has a current value of $90,000. Some companies calculate the free withdrawal based on the greater of current value or principal contributions.
A few companies allow withdrawals of up to 15% per year. Whatever rate the company allows, keep in mind two points: close to 75% of all people who invest in an annuity never take any money out, and the restrictions on withdrawals eventually disappear. The aforementioned restrictions simply mean that the contract owner can take out more than, say, 10% per year, but he or she will pay a
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penalty. The amount of penalty depends on the type of contract that the contract owner has and the insurance company.
Settlement Alternatives When the contract owner is ready to withdraw the money that he or she has accumulated in a Flexible Premium Fixed Annuity policy, he or she may choose how it will be received.
Full Surrender - Upon request, the insurer will send the cash value minus any applicable charges as specified in the policy.
Life Annuity - A contract owner may use the money in the policy to generate an income for the remainder of his or her life. The amount of this income will depend on how much money has accumulated in the policy, how old the individual is, and what the lifetime annuity interest rates are, among other factors. Shortly before the policy's Annuity Commencement Date, the contract owner will receive a written notice reminding him or her of the ability to use the policy's cash value to generate a lifetime income. An individual may defer the settlement of the policy until he or she wants to receive money, and it will continue to grow tax-deferred as long as it remains in the Flexible Premium Fixed Annuity policy.
Straight Life Option With this option, the contract owner gets paid for the rest of his or her life. And when the individual dies, the payments stop. With this option, the insurance company keeps whatever payments it does not have to make to the contract owner. If the contract owner lives an expected life span, which most people do, he or she will get a fair deal and the insurance company gets a fair deal.
Life Annuity With Period Certain With this option one still receives annuity payments for life. However, the contract owner and the insurance company decide on a certain amount of years in which the annuity is guaranteed. If he or she does not live that long, the annuity will continue to be paid to a stated beneficiary. For example, the contract owner buys a life annuity with 10-years certain. Then he or she dies 6 years after the payout begins. For the next 4 years a stated beneficiary will receive the annuity payments. Conversely, if an individual buys a life annuity with 10 years certain and he or she lives for 25 years after the annuity starts paying, the beneficiary will receive nothing. The monthly payout is less with a period certain annuity. This is because the contract owner is asking the insurance company to guarantee payments even if he or she dies. Since the insurance company has anticipated some people dying early, the insurance company charges (in the form of reduced payments) for this benefit. The investor receives a lower return for accepting lower risk.
Joint and Survivor Annuity - With this option, the annuitant will receive his annuity payments for as long as he lives. Upon his or her death, a percentage of his annuity will continue to be paid to a beneficiary for as long as they live. The percentage can be as low or as high as an individual wants and which the insurance company offers. 50% is a common percentage for this. The theory behind this is that when a husband dies, his wife will require less than they were previously getting. Of course, this benefit comes with a price. The payout is lower than any of the other two previously mentioned.
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Lump Sum Payout - With this payout, the annuitant receives one lump sum payout. The drawback is that taxes have to be paid on this. And they are taxed as ordinary income. When an annuitant chooses the monthly payout options, the amount of each monthly payment that represents accumulated earnings which have not yet been taxed are taxed. The IRS has a formula for determining how much of each monthly payment should be taxed options for receiving income from an annuity.
With variable annuities, there is no locked-in or guaranteed rate. Instead, one’s return is based on the returns of the portfolios that he selects – in other words, the investment risk gets passed from insurer to contract holder. This offers investors a chance to earn substantially higher returns than would be available on a fixed account, but the return could also be lower -- it is certainly more variable.
Death Benefit The principal is guaranteed every day in a fixed-rate annuity. In event of the death of a contract owner, the beneficiary(ies) will receive the policy's full cash value. The death benefit is paid directly to the chosen beneficiary(ies), bypassing the costs and delays of the probate process. The death benefit must be taken by the beneficiary(ies) as a lump sum within five years of the death of the contract owner or be annuitized into a stream of payments within one year of the death of the owner. If a spouse is the primary beneficiary of the policy, then, upon a death, he or she may be eligible to continue to defer taxes by electing to assume ownership of the policy.
A guaranteed death benefit is of no added benefit for an investment that carries such an assurance. Variable annuities automatically contain a guaranteed death benefit. The guarantee works like this. Upon the death of the annuitant, the beneficiary will receive the greater of the principal, plus any ongoing additions, or the value of the account as of the annuitant’s date of death. This guaranteed death benefit makes the variable annuity an ideal investment for an older couple that wants a high income stream or growth to offset inflation. One spouse can name himself or herself as the annuitant and invest in one or more of the stock or bond sub accounts, knowing that upon death the survivor will get back the greater of the amount invested or the current value of the annuity.
The guaranteed death benefit is based on the greater of all contributions or the value on the date of the annuitant’s death, whichever is higher. The guaranteed death benefit lasts until he or she terminates the contract; annuitize the investment, the annuitant dies, or the annuitant reaches a certain age.
Survivor Benefit Plan (SBP) This plan provides supplemental spouse coverage and payment of annuity amount.
Commencement of Annuity
A supplemental spouse annuity commences on the later of the day on which an annuity under the Survivor Benefit Plan becomes payable to the beneficiary; or the first day of the first month after the month in which the beneficiary becomes 62 years of age.
Amount of Annuity for Beneficiary of Person Providing Standard Annuity In the case of a person providing a standard annuity for a spouse or former spouse beneficiary under the Survivor Benefit Plan and providing a supplemental spouse annuity for that beneficiary, the
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monthly annuity payable to the beneficiary under this subchapter is the amount equal to 5, 10, 15, or 20 percent of the base amount under the Survivor Benefit Plan of the person providing the annuity, as specified by that person when electing to provide the annuity. The annuity should be computed as of the date of the death of the person providing the annuity, notwithstanding that the annuity is not payable at that time by reason of subsection.
Amount of Annuity for Beneficiary of Person Providing Reserve-Component Annuity In the case of a person providing a reserve-component annuity for a spouse or former spouse beneficiary under the Survivor Benefit Plan and providing a supplemental spouse annuity for that beneficiary under this subchapter, the monthly annuity payable to that beneficiary under this subchapter shall be determined as follows:
Adjustments in Annuities Periodic adjustments (colas) Whenever annuities under the Survivor Benefit Plan are increased or recomputed each annuity should be increased or recomputed at the same time. The increase should, in the case of any such annuity, be by the same percent as the percent by which the annuity of that beneficiary is increased or recomputed under the Survivor Benefit Plan.
Rounding down The monthly amount of an annuity payable under this subchapter, if not a multiple of $1, shall be rounded to the next lower multiple of $1.
Termination of Annuity A supplemental spouse annuity terminates effective as of the first day of the month in which the beneficiary dies or otherwise becomes ineligible to continue to receive an annuity under the Survivor Benefit Plan.
Riders In states where they have been approved, two riders are automatically added to all policies at no charge.
Living Needs Benefit Rider If the annuitant is confined to a nursing home or becomes terminally ill or disabled, he or she can have immediate access to his/her money without incurring surrender charges.
Unemployment Benefit Rider If the owner becomes unemployed, he or she may make a one-time, surrender charge-free withdrawal for up to 50% of his/her cash value.
Tax-Deferred Growth The interest or growth on annuity investment is taxable in the year in which it was withdrawn and only on the amount actually received. One of the reasons that it is tax-deferred is that the IRS never taxes a return of principal. In fact, participants in annuities purchased before 1981 can opt to withdraw principal first and growth or interest later. By utilizing such a strategy, no taxes would be
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paid on any of the redemption's until such cumulative withdrawals equaled the contract owner’s contributions or the principal.
The avoidance of income taxes can continue indefinitely. The death of the annuitant would normally mean that the contract is terminated. However, if one spouse is named as the contract owner and the annuitant and the other spouse is named as the beneficiary, the contract can continue. The surviving spouse has the option of liquidating part or all of the investment without cost, fee, or penalty by either the IRS or the issuer. Withdrawals or complete liquidations trigger an income tax event to the extent that any monies the survivor receives are considered growth or interest.
The best to least ways of investing are in the following order:
• Tax-deductible and tax-deferred investments
• Tax-deferred
• Taxable investments
IRA investments are both tax deductible and tax deferred, because one can deduct any IRA payment up to $2,000 from their gross income before they pay taxes on it. That money and everything else that accumulates in the IRA is also tax deferred. No taxes are paid on its appreciation or the interest until the investor begins taking money out. While annuities are tax-deferred, with mutual funds one must pay taxes as he goes along according to the interest and dividends he earns and capital appreciation when he sells. This gives annuities preference over mutual funds. Over time, tax-deferral compounding is very powerful.
The Insurance Component Besides providing tax-deferral benefits, the insurance portion of variable annuities provides two additional benefits as well. First, it provides a modicum of life insurance that guarantees the principal if one dies while the annuity is in force (with a fixed annuity, the principal is guaranteed even if one withdraws the money before he dies). Second, it makes sure the annuity continues to pay the annuitant the amount specified in the annuity for as long as he lives, even if that’s to age 105 or more.
Most annuity holders will never use the life insurance that comes with annuities. The usefulness comes into force in regard to heirs. For example, the annuitant wants to leave all the money in his annuity to his heirs. In order to leave as much as possible, he becomes a very aggressive, risk-taking investor. If his investments work out, his heirs get more money than if he had been conservative. If he suffers losses, the insurance guarantees that when he dies, his heirs get all the money he originally put into the annuity. There cannot be any loss of principal.
The insurance component is the variable annuity’s enormous advantage over mutual funds. The money one pays into the annuity accrues tax-free until he starts taking it out. Many, late in life, have less income than when they were younger and so are in a lower tax bracket. They pay less of their accumulated gains back to the government as taxes, so the longer they hold off paying taxes, the more they gain. Even if their income and tax bracket rise, they still come out ahead because of those years of tax-deferral.
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The annuity functions somewhat like a nondeductible IRA (the kind where one is not eligible to deduct contributions from his taxable income), with such features as tax deferral and early withdrawal penalties. One important advantage of an annuity over an IRA is that there is no maximum contribution one can make to an annuity, unlike the IRA’s $4,000 (2005) annual limit. The appropriate use of variable annuities is for retirement planning or sheltering income on investments.
Tax-Free Exchanges Sometimes a contract owner goes into one investment and later discovers that it is not what he or she wanted or its quality has changed. One of the advantages of annuities is that he or she can change companies for whatever reason. This move is known as a 1035 Exchange or a Tax-Free Exchange since he or she does not pay any taxes. The only time the contract owner pays taxes on the growth or interest in an annuity is when he or she makes withdrawals or a complete liquidation. To take advantage of a tax-free exchange, the money from one insurer must go directly to another insurance company. The check cannot be sent to the contract owner first. The IRS allows such 1035 Exchanges because the money is never seen or touched by anyone except the insurers.
Tax-free exchanges are simple to do. The contract owner simply finds a new annuity that he or she wants to have the contract moved to and fills out the company’s application along with a separate form identified as a 1035 Exchange Request. The contract owner then sends these two forms along with the existing contract to the new company. The new insurer takes care of the rest. If he or she cannot find the existing contract, which is usually a few dozen pages in length, he or she simply fills out a lost contract form and sends it to the company to which the assets will be transferred. Although 1035 Exchanges are straightforward and do not trigger an IRS penalty or tax, the insurance company may charge a penalty. Whether or not an insurance company penalty will occur depends on the specifics of the contract. Normally, no penalties occur if the money has stayed with the original issuer for a certain number of years.
Transferring Annuities What happens when one has built up some sizable value in his deferred annuity contracts and is concerned about transferring this asset to his child? The greatest wealth accumulation vehicle, the deferred annuity, by itself is not a very efficient method for transferring wealth, as the following example demonstrates:
Suppose one is 70 years old and he invested $100,000 in an annuity contract 20 years ago. If he earned 10 percent a year over this 20 year period, his contract is worth $750,000. He has an estate (excluding the annuity) in excess of $1,500,000 (2005) and he is in the 37 percent marginal estate tax bracket. He also names his son as the annuity beneficiary and he is in a 35 percent income tax bracket. What would happen to the contract’s account value if he dies today and the annuity value was transferred to his son?
To An Heir His son would receive just over one-third of the contract’s value. The rest would be lost to estate and income taxes. Since the investor owned the contract at his death, its value is included in his taxable estate. The gains in the contract’s value are also completely income-taxable to his son, since there is no step-up in cost basis at the death of an annuity owner. So to avoid estate taxes on the annuity value, he suggests transferring the contract to his son as a gift. He doesn’t think he will need any
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income from the contract. If an annuity contract is given to an individual to whom the owner is not married, not only may there be a gift-tax consequence, but the contract owner will recognize all of the interest and gain earned inside the contract over the years as taxable income in the year of the transfer. This applies to annuity contracts issued after April 22, 1987. Contracts issued before April 23, 1987 are treated differently, with the interest and gain recognized by the donor if and when the donor surrenders the annuity contract. Only married individuals can transfer annuity contracts to each other without triggering any of this income recognition.
Instead of giving away the annuity contract, a possible solution is available by using the contract itself. The purpose behind an annuity contract is to provide a guaranteed income stream for either a number of years or over the annuitant’s lifetime. By selecting an immediate income option, either from the original contract or through a tax-free exchange to a more competitive immediate annuity, one can increase his current income and spread the taxable gain in the deferred annuity contract over the years he receives the payments.
If one is under age 59½ there could be a 10 percent premature distribution tax. If he selects a life only annuity, annuity payments stop at the annuitant’s death and there is no contract value included in his estate.
To A Spouse What about a married couple? Between spouses, not only can an annuity contract be transferred during their lifetimes without any income recognition, but a tax-deferred annuity can usually be transferred at the death of the owner to his or her spouse on a tax-deferred basis.
Each contract must be reviewed carefully to make sure this can be achieved at the death of the primary annuitant and/or owner. With the availability of the unlimited marital deduction for estate taxes, neither income nor estate taxes would occur at the first spouse’s death, but at the second spouse’s death, non-spousal beneficiaries must deal with possible income and estate taxes.
The planning process for a married couple is often similar to that of a single individual. However, the immediate annuity option chosen might be a joint-and-survivor one and the life insurance policy used might be a second-to-die contract. Depending upon the couple’s financial and estate-planning situation, using a joint-and-survivor immediate annuity and a second-to-die life insurance policy would allow them to accomplish the same transfer objective as a single person.
Funding a Life Insurance Policy What about a benefit for one’s son? In our scenario, the investor may think he doesn’t need the annuity income to pay living expenses. He could convert the contract value into an income stream to fund a life insurance policy owned by an irrevocable trust for his son. Unlike the annuity contract, the proceeds from a life insurance policy are generally income-tax free. In addition, if the life insurance policy is owned by a third party from the start, e.g. a trust, one should be able to keep the proceeds out of his taxable estate.
The immediate annuity income he receives will be partially income taxable, as the gain from the deferred annuity contract is spread over the years of payment. One might keep part of the income to pay the related taxes; then he could give some or all of the remainder to an irrevocable trust or to his
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son with which he can pay the life insurance premiums. A number of strategies could be employed with such transfers to minimize gift tax consequences, too.
Perhaps one owns a tax-deferred annuity contract but does not have a sizable estate. Is there any reason to select an immediate annuity and fund a permanent life insurance policy? The answer is yes, if the annuitant does not need current or future income from the annuity contract and the idea of maximizing wealth for transfer to heirs is appealing.
In this situation, he could own the life insurance policy and have access to the cash value should the need arise. However, at death, unlike the annuity contract proceeds, the life insurance death benefit would generally pass to the named beneficiary income-tax free.
In addition, the leveraging associated with a life insurance policy’s death benefit might help him leave his son a lot more cash than could have been achieved with other assets. Of course, the policy proceeds would be included in his taxable estate if he owned the policy at death.
The Accumulation Phase During the accumulation stage of a deferred annuity, one is putting money into the investment. He can purchase an annuity by paying either a single premium or by paying into the contract periodically.
Periodic payments to variable annuities are in the form of "accumulation units," which are similar to mutual fund shares. The "accumulation unit value" is analogous to a mutual fund's net asset value. Unlike a mutual fund, however, a variable annuity does not distribute income or capital gains to investors, so its accumulation unit value builds up over a period of years.
During the accumulation phase the retained income and capital gains grow tax-deferred, as in a voluntary retirement plan.
It is also during the accumulation phase that the minimum death benefit is applicable. This protects one’s beneficiary against any market losses during the accumulation period. The death benefit really isn't an important reason for purchasing a variable annuity. It provides a modest security blanket for people who worry about low-probability, worst-case scenarios of losing money within the first few years of buying an annuity.
The Payout, Distribution, or Annuitization Phase In the payout phase, the insurance company pays out the accumulated value of the annuity, consisting of both the original principal and earnings, to the annuitant or to a named beneficiary. The payment can either be a lump sum, or it can be annuitized--that is, it consists of a series of payments for a defined period.
If one makes withdrawals from an annuity before age 59 1/2, there is a 10% penalty tax imposed on accumulated earnings, similar to the early withdrawal penalty for IRAs. However, no penalty would apply if he becomes disabled or dies. One way to avoid the early withdrawal penalty is to annuitize, taking regular payments for the remainder of one’s life.
What about taxes on payments? The annuitant must pay taxes on the portion of the payment that represents earnings. Alternatively, he can compound his money tax-deferred until age 85 before making his first withdrawal.
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Break Even Phase An important question to ask about a variable annuity is how long it will take before the tax-deferred growth begins to outweigh one’s additional expenses, making him better off with the annuity than with a regular fund. The following factors would lead to a shorter break-even time:
• Lower costs,
• A higher tax bracket, and
• Higher investment returns.
The latter factor is an important consideration--aggressive growth, growth and income, and international stock portfolios would tend to provide an investor with greater returns than fixed-income funds, so it makes less sense to buy a variable annuity if one does not want to invest in these kinds of portfolios. The variable annuity is where the most aggressive part of one’s portfolio should be, provided he can tolerate a risky component.
The annuitant is going to want to stay put for a long time if he faces stiff surrender charges. For this reason, he will have to be extra cautious before buying. Since he will probably switch among different funds within a family eventually, he will want a group that offers an attractive menu. It is best to choose a large, well-known complex that has a reputation for superior returns and reasonable expenses.
Because of the higher costs associated with annuities, one should first invest as much as he can in regular retirement plans, such as the 401(k), IRA, and Keogh. If he still has money to put away on a tax-sheltered basis, then he can start thinking about a variable annuity. Obviously, he wouldn't want to hold a variable annuity in an IRA account, just as he wouldn't want a tax-exempt bond fund put into an IRA. He would be placing one tax shelter into another, a major mistake.
Finally, variable annuities offer a brief grace, or "examination," period during which one can change his mind if the contract does not suit him. If disappointed, he can exit after a few days without any penalty
When one invests in a variable annuity, his money is pooled with that of thousands of other investors. This large pool of money is overseen by portfolio managers who invest it in one or more types of investments. The universe of investments includes:
• Common stocks
• Preferred stocks
• Foreign securities
• Corporate bonds
• U.S. Government obligations
• Zero coupon bonds
• Convertible securities
• Money market instruments
• Gold, silver, and real estate
The amount of money invested in one or more of these categories depends on the variable annuity’s objectives and restrictions, and on management’s perception of the economy. The investor decides which of these portfolios or sub-accounts his money will be invested in and what dollar figure goes into each fund.
Once an investor decides on the type of investment desired, variable annuities offer several portfolios, known as sub-accounts, which fulfill the criteria. The track record of these sub-accounts can be easily obtained. Some variable annuity sources even look at a sub-account’s risk-adjusted return.
Performance Investors and financial advisors are not concerned with mediocre or poor performers; they simply want the best variable annuity sub account(s), given certain parameters. Personal investment considerations include one’s time horizon, existing portfolio, tax bracket, financial goals, and risk tolerance. Parameters within a given sub account category (growth, corporate bond, international stock) include performance, risk, and consistency.
Newspapers and periodicals that cover variable annuities focus on how a sub-account or variable annuity family has performed in the past. Studies clearly point out that when a sub-account’s
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performance is in the top half one year, it has a 50-50 chance of being in the bottom half the next year, or the year after that.
Researchers have scoured their data banks repeatedly, searching for even a hint of evidence to support the notion that choosing funds based on historic results makes sense. They usually reach the same conclusion that past performance does not help in predicting future returns. Because variable annuities share a great number of similarities with these products and are often entrusted to the same managers, they believe that this would apply to them as well.
Management A variable annuity is an investment company, an entity that makes investments on behalf of individuals and institutions that share common financial goals. The sub-accounts pool the money of many people, each of which invests a different amount. Some variable annuities allow initial investments of as little as $10; others require at least $10,000.
Professional money managers for each sub-account use the pool of money to buy a variety of stocks, bonds, or money market instruments that, in their judgment, will help the sub-account’s shareholders achieve their financial objectives. The objective of the manager is easy to discern. If the sub-account is called the “ABC Growth Portfolio,” it is safe to assume that most, if not all, of the portfolio is comprised of common stocks. If the name of the sub-account is the “ABC High-Yield Portfolio,” one can assume that management is concentrating on high-yield corporate bonds. Whether the amount invested is $100 or $1 million, each investor gets the same percentage yield, or return, as everyone else in the sub-account.
Investment Objective Each sub-account’s investment objective, described in the prospectus, is important to both the portfolio’s manager and the potential investor. The manager uses it as a guide when choosing investments for the sub-account. Prospective investors use it to determine which sub-accounts are suitable for their needs. By law, each investor must receive a prospectus prior to or at the time of the investment. The prospectus details investment objectives and restrictions as well as all of the costs and expenses associated with the investment. Variable annuity investment objectives cover a wide range. Those in search of higher returns follow aggressive investment policies that involve greater risk; others seek current income from more conservative investments.
When a sub-account earns money — dividends, interest, and/or capital gains - it does not automatically distribute them to the investors. Unless the contract owner makes a request for the money, it is reinvested. The automatic reinvestment is reflected in an increase in the price per unit of the variable annuity sub account. All variable annuity profits are reflected in an increased value per unit.
Popularity Variable annuities are popular because they are convenient and efficient investment vehicles that give all individuals – even those with small sums to invest – access to a splendid array of opportunities. Variable annuities are uniquely democratic institutions. They can take a portfolio of giant blue-chip companies like IBM, General Electric, and General Motors, and slice it into small enough pieces that almost anyone can buy.
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Variable annuities allow an opportunity to participate in foreign stock and bond markets, which would normally be inaccessible because of time, expertise, or expense. International sub-accounts make investing across sovereign borders no more difficult than investing across state lines.
Mechanics A variable annuity sub-account is owned by all of its contract owners (shareholders), the people who purchased units of the sub-account. The day-to-day operation of a sub account is delegated to a management company, which is often an outside mutual fund group, or the organization that created the variable annuity. This company may offer other financial products and services as well as different kinds of insurance.
The investment advisor manages the sub-account’s portfolio of securities. The advisor is paid for its services; the fee is based on the total value of the fund’s assets. The advisor employs professional portfolio managers who invest the sub account’s money by purchasing a number of stocks, bonds, or money market instruments, depending on the portfolio’s investment objective.
These professionals decided where to invest the sub-account’s assets. The money managers make their investment decisions based on extensive, ongoing research into the financial performance of individual companies, taking into account general economic and market trends. They are backed up by economic and statistical resources. On the basis of their research, money managers decide what and when to buy, sell, or hold for the portfolio, in light of the sub-account’s specific investment objective.
The variable annuity company may also contract with an underwriter, who arranges for the distribution of the sub account’s units to the investing public. The underwriter may act as a wholesaler, selling units to security dealers, or it may retail directly to the public.
The Contract An annuity represents a contractual relationship between the investor and an insurance company. Although offered only by the insurance industry, annuities do not have anything to do with any type of insurance coverage. They are marketed and sold through brokerage firms, insurance agencies, banks, savings and loan institutions, financial planners, and investment advisors.
The contract owner is given certain assurances by the insurance company. These promises depend on the company issuing the contract, and the type of annuity chosen.
There are two different types of annuities:
• Fixed – a set rate of return
• Variable – the investor chooses from a series of portfolios that range from conservative to aggressive
There are always four parties to each annuity:
• The insurer
• The contract owner
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• The beneficiary The Investment Investing in a variable annuity means buying units (shares) of one or more sub accounts. An investor becomes an owner of a set number of units in a sub account, just as he or she might be an owner of a designated number of shares of stock in a large corporation. The difference is that a variable annuity’s only business is investing in securities; the price of the units in any given sub-account is directly related to the value of the securities held by that specific sub-account.
Variable annuity sub-accounts continually issue new shares for purchase by the public. Existing investors’ (contract owners’) price per unit does not decrease because of the ongoing issuance of new units (shares). Each unit created is offset by the amount of new money coming in. A sub-account’s unit price can change from day to day, depending on the daily value of the securities held in the portfolio. The unit price is calculated by dividing the total value of the sub-account’s investments after expenses at the end of the day by the number of units outstanding.
Newspapers do not report on variable annuity sub-accounts. A weekly publication, Barron’s, reports the values of sub-accounts.
Ratings Sub-accounts have been rated according to:
• Performance
• Risk control
• Expense minimization
• Management
• Investment options
• Family rating Performance Return figures and the subsequent ratings are sometimes based on three calendar years. Performance figures represent total return figures: Unit appreciation plus any dividends or interest payments are included.
Risk Control Risk-adjusted return looks at how well an account performed, based on the amount of risk it took. Anyone would like to get a great return on an investment without taking much risk, but this is not usually possible. Usually risk is commensurate with return. If an account receives high marks for risk control, this means that the fund took X amount of risk but received an X plus Y rate of return. One should not necessarily avoid variable annuities that are rated either fair or poor for risk control;
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a higher-than-normal risk can be counterbalanced by the addition of a low-risk investment to one’s portfolio.
Expense Minimization The impact of expense minimization is often exaggerated by the press and by investors and advisors who focus on statistics. Even though it is true that over time a .25% added expense will have a minor impact on total return, this is not nearly as important as whether one is in the right category to begin with, or whether his sub-account has a good portfolio manager who is conscious of risk-adjusted returns.
Management The sub-account must either possess an excellent risk-adjusted return or have had superior returns with very low levels of risk. The rating for this characteristic is based on the sub-account’s performance and risk control, both of which are usually heavily influenced by management.
Investment Options The rating for this characteristic is based on the number of sub-accounts available within the variable annuity family and the diversification of such choices or options.
Family Rating This characteristic points out how many sub-accounts are available within the variable annuity contract and the caliber of these investment options, based on their respective risk-adjusted returns. The number of choices offered to the investor could have only four sub-accounts, but still get an excellent rating if most or all of the sub-accounts performed superbly, when viewed on a risk-adjusted return basis.
Categories Aggressive Growth Sub-accounts These sub-accounts focus strictly on appreciation, with no concern about generating income. Aggressive growth sub-accounts strive for capital growth, frequently using such trading strategies as
• leveraging
• purchasing restricted securities
• buying stocks of emerging growth companies.
Portfolio composition is almost always completely comprised of U.S. stocks. Aggressive growth sub-accounts can go up in value quite rapidly during favorable market conditions. They will often outperform other categories of U.S. stocks during bull markets, but suffer greater percentage losses during bear markets.
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Balanced Sub-accounts The objective of balanced sub-accounts, also referred to as total return sub-accounts, is to provide both growth and income. Sub-account management purchases
• Common stocks
• Bonds
• Convertible securities
Portfolio composition is almost always completely comprised of U.S. securities. Weighting of stocks versus bonds depends on the portfolio manager’s perception of the stock market, interest rates, and risk levels.
Balanced sub-accounts offer neither the best nor the worst of both worlds. These sub-accounts will often outperform the different categories of bond sub-accounts during bull markets, but suffer great percentage losses during stock market declines. Conversely, when interest rates are on the rise, balanced sub-accounts will typically decline less on a total return basis than a bond sub-account. When rates are falling, balanced sub-accounts can also outperform bond sub-accounts if stocks are also doing well.
Balanced sub-accounts are the perfect choice for the investor who cannot decide between stocks and bonds. This hybrid security is a middle-of-the-road approach, ideal for someone who wants a sub-account manager to determine the portfolio’s weighting of stocks, bonds, and convertibles.
Corporate Bond Sub-accounts Traditionally, bond sub-accounts are held by investors who require stability and low risk. Corporate bond sub-accounts are primarily comprised of bonds issued by corporations. Portfolio composition is almost always completely comprised of U.S. issues.
Normally purchased because of its reinvested income stream, one’s principal in a bond sub-account can fluctuate. The major influence on bond prices, and therefore the value of the underlying sub-account is interest rates. There is an inverse relationship between interest rates and bond values; whatever one does, the other does the opposite. If interest rates rise, the price of a bond sub-account will fall, and vice versa. Gains or losses are increased or offset by the yield from the bonds.
The amount of appreciation or loss of a corporate bond sub-account primarily depends on the average maturity of the bonds in the portfolio and the yield of the bonds in the sub-account’s portfolio. Short-term bond sub-accounts, comprised of debt instruments with an average maturity of 5 years or less, are subject to very little interest rate risk or reward. Medium-term bond sub-accounts, with maturities averaging between 6 and 15 years, are subject to one-third to one-half the risk level of long-term sub-accounts. A long-term corporate bond (maturity ranging from 16 to 30 years) sub-account will average an 8% increase or decrease in share price for every cumulative 1% change in interest rates.
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Global Stock Sub-accounts International (foreign) sub-accounts invest only in stocks of foreign companies; global sub-accounts invest in both foreign and U.S. stocks. It is wise to consider investing abroad because different economies experience prosperity and recession at different times.
The economic outlook of foreign countries is the major factor in management’s decision regarding which nations and industries are to be favored. A secondary concern is the future anticipated value of the U.S. dollar relative to foreign currencies. A strong or weak dollar can detract or add to an international sub-account’s overall performance. A strong dollar will lower a foreign portfolio’s return; a weak dollar will enhance international performance.
Investors who want to avoid being subjected to currency swings may wish to use, for their foreign holdings, a sub-account family that practices currency hedging. With currency hedging, management is buying a type of “insurance policy” that pays off in the event of a strong U.S. dollar. Basically, the foreign or international sub-account that is being hurt by the dollar is making a killing in currency futures contracts. When properly done, the gains in the futures contracts (the insurance policy) offset most or all of the security losses attributed to a strong dollar.
Like automobile insurance, currency hedging only pays off if there is an accident, that is, if the U.S. dollar increases in value against the currencies represented by the portfolio’s securities. If the dollar remains level or decreases in value, so much the better; the foreign securities increase in value and the currency contracts become virtually worthless. The price of these contracts becomes a cost of doing business; just like car insurance, the protection is simply renewed. With a currency contract, the contract expires and a new one, covering another period of time, is purchased.
Two compelling reasons for investing worldwide are
• To increase one’s investment returns
• To reduce one’s portfolio risk
Global investing allows the investor to maximize his returns by investing in some of the world’s best-managed and most profitable companies. The most potential for growth today is in countries that:
• Are industrializing
• Have the cheapest labor
• Have the richest natural resources
• Remain undervalued
Diversification reduces investment risk.
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Government Bond Sub-accounts These sub-accounts invest in direct and indirect U.S. government obligations. Government bond sub-accounts are comprise of one or more of the following:
• Treasury Bills, Notes, and Bonds which comprise the entire marketable debt of the U.S. government
• Government National Mortgage Association bonds(GNMAs), which are considered an indirect obligation of the government, but are still backed by the full faith and credit of the United States
• Federal National Mortgage Association bonds, which are not issued by the government, but are considered virtually identical in safety to GNMAs
The average maturity of securities found in government bond sub-accounts ranges quite a bit, depending on the type of sub-account and management’s perception of risk and of the future direction of interest rates. Surveys usually show that government bonds under-performed long-term corporate bonds only slightly. Within a longer time frame, government bonds have only slightly outperformed inflation.
Government bond sub-accounts are the perfect choice for the conservative investor who wants to avoid any possibility of defaults. They should probably be avoided by most moderate investors and all aggressive portfolios.
The prospective investor should always remember that government and corporate bonds are generally not a good investment, once inflation and taxes are factored in. Either the investor or his heirs will eventually have to pay taxes on the accumulated growth and/or interest.
Growth Sub-accounts These sub-accounts generally seek capital appreciation, with current income as a distant secondary concern. Growth sub-accounts typically invest in U.S. common stocks while avoiding speculative issues and aggressive trading techniques. The goal of most of these sub-accounts is long-term growth. The approaches used to attain this appreciation can vary significantly among growth sub-accounts.
Over the past half-century, growth stocks have outperformed bonds in every single decade. If President George Washington had invested $1 in common stocks with an average return of 12%, his investment would be worth over $68 billion today. If he had averaged 14% on his stock portfolio, his portfolio would be large enough to pay our national debt several times over.
Growth sub-accounts should be a part of everyone’s holdings. As with any category of variable annuities, whenever larger dollar amounts are involved, more than one sub-account per category should be used.
Growth and Income Sub-accounts These sub-accounts attempt to produce both capital appreciation and current income, with priority given to appreciation potential in the stocks purchased. Growth and income sub-account portfolios
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include seasoned, well-established firms that pay relatively high cash dividends. The goal of these sub-accounts is to provide long-term growth without excessive volatility in share price.
Portfolio composition is almost exclusively comprised of U.S. stocks with an emphasis on utility, computer, energy, retail, and financial common stocks. By selecting securities that have comparatively high yields, overall risk is reduced; dividends will help prop up the overall return of growth and income sub-accounts during negative market conditions.
High-Yield Bond Sub-accounts Sometimes referred to as junk bond sub-accounts, these portfolios invest in corporate bonds rated lower than BBB or BAA. The world of bonds is divided into two general categories:
• Investment grade
• High-yield
Investment grade, sometimes referred to as bank quality, means that the bond issue has been rated AAA, AA, A, or BAA. Certain institutions and fiduciaries are forbidden to invest their clients’ monies in anything less than investment grade. Everything less than bank quality is considered junk.
The world of bonds is not black and white. There are several categories of high-yield bonds. Junk bond sub-accounts contain issues that range from BBB to C; a rating less than single-C means that the bond is in default, and payment of interest and/or principal is in arrears. High-yield bond sub-accounts perform best during good economic times. Such issues should be avoided by traditional investors during recessionary periods because the underlying corporations may have difficulty making interest and principal payments when business slows down. However, these bonds, like common stocks, can perform very well during the second half of a recession.
Although junk bonds may exhibit great volatility than their investment grade peers, they are safer when it comes to interest rate risk. Because junk issues have high-yielding coupons and shorter maturities than quality corporate bond sub-accounts, they fluctuate less in value when interest rates change. Thus, during expansionary periods in the economy, when interest rates are rising, high-yield sub-accounts will generally drop less in value than high-quality corporate or government bond sub-accounts. Conversely, when interest rates are falling, government or corporate bonds will often appreciate more in value than junk sub-accounts.
Specialty Sub-accounts These sub-accounts primarily invest in the common stocks of a single industry, or sector, such as natural resources like timber or mining, or real estate. Traditionally, most if not all of the companies represented in these sub-accounts are domestic.
Specialty sub-accounts are the most volatile group one can invest in, particularly when the definition of specialty includes metals funds. Utilities are the most conservative industry within this broad category. Despite its often high levels of volatility, this category can actually reduce the overall level of risk of one’s portfolio because specialty sub-accounts can have a random or negative correlation.
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Utility Stock Sub-accounts These sub-accounts look for both growth and income, and they invest in common stocks of utility companies across the country. Utility sub-accounts normally stay away from speculative issues; instead, they focus on well-established companies that have a solid history of paying good dividends. The goal of most of these sub-accounts is long-term growth. Utility sub-accounts sound safe and are safe. Any category of stocks that relies fairly heavily on a high level of reinvested dividends has a built-in safety cushion.
Four things generally determine the profitability of a utility company:
• How much it pays for energy
• The general level of interest rates
• The company’s expected use of nuclear power
• The political climate
The price of oil and gas is directly passed on to the consumer, but the utility companies are sensitive to this issue. Higher fuel prices mean that the utility industry has less latitude to increase its profit margins. Higher fuel prices can mean smaller profits and/or dividends to investors.
Next to energy costs, interest is the industry’s greatest expense. Utility companies are heavily debt-laden. Their interest costs directly affect their profitability. When rates go down and companies are able to refinance their debt, the savings can be enormous.
Nuclear power has been an issue for the United States for a few decades. Venturing into nuclear power always seems to be much more expensive than ever anticipated by the utility companies and the independent experts they rely on for advice. Because of these uncertainties, sub-account managers try to seek out utility companies that have no foreseeable plans to develop any, or more, nuclear power facilities.
The Public Utilities Commission is a political force and can directly reflect the views of a state’s government. Modest or minimum increases in utility rates can be healthy for the utility companies; freezing rates for a couple of years is a bad sign. Utility stock prices closely follow the long-term bond market. If the economy surges and long-term interest rates go up, utility stock prices are likely to go down. Utility stocks are also vulnerable to a general stock market decline, although they are considered less risky than other types of common stock because of their dividends and the monopoly position of most utilities.
Worldwide, there is a tremendous opportunity for growth in this industry. All over the world, previously underdeveloped countries are making economic strides as they move toward a free market system. When emerging countries become developed economically, their citizens demand higher standards of living. As a result, their requirements for electricity, water, and telephones should rise dramatically.
The net result of all this for investors is that variable annuities are beginning to offer global utilities sub-accounts. Increased diversification – allowing a sub-account to invest in utility companies all
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over the world instead of just in the United States – couples with tremendous long-term growth potential, should make this a dynamic industry group for the next few decades.
World Bond Sub-accounts World bond, also known as global bond, sub-accounts invest in securities issued all over the world, including the United States. A world bond sub-account usually invests in bonds issued by stable governments in a handful of countries. These sub-accounts try to avoid purchasing foreign government debt instruments from politically or economically unstable nations.
World bond sub-accounts seek higher interest rates, no matter where the search may take them. Inclusion into the portfolio is dependent on management’s perception of interest rates, the country’s projected currency strength against the U.S. dollar, and the predicted political and economic stability.
Assessing the economic environment to evaluate its effects on interest rates and bond values requires an understanding of two important factors - inflation and supply. During inflationary periods, when there is too much money chasing too few goods, government tightening of the money supply helps create a balance between an economy’s cash resources and its available goods. Money supply refers to the amount of cash made available for spending, borrowing, or investing. Controlled by the central banks of each nation, money supply is a primary tool for managing inflation, interest rates, and economic growth. A prudent tightening of the money supply can help bring on deflation – decelerated loan demand, reduced durable goods orders, and falling prices. Although such factors ultimately contribute to a healthier economy, they also mean lower yields for government bond investors.
Even with high income as the primary goal, investors must consider credit and market risk. By investing primarily in variable annuity sub-accounts that purchase government-guaranteed bonds from the world’s most creditworthy nations, one can get an extra measure of credit safety for payment of interest and repayment of principal. By diversifying across multiple markets, sub-account managers can significantly reduce market risk as well. Diversification is a proven technique for controlling market risk.
Most investors understand the concept of investing in global bonds for the income, or yield, they provide. However, may investors do not realize that global bonds may offer more than just yield. Successful management of global bond portfolios has three components:
• Capital appreciation
• Yield
• Currency management
Investors searching strictly for high yields may lose out on capital appreciation opportunities. Those looking solely for capital appreciation often give up current income. Individuals who invest in global bonds without applying the principles of currency management can see their investment erode when exchanges rates change adversely.
Investing in global bonds provides the potential for capital appreciation during periods of declining interest rates. An inverse relationship exists between bond values and interest rates. When interest
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rates fall, as is the case in most bond markets in the world today, existing bond values climb. Conversely, as interest rates rise, the value of existing bonds declines. World bond sub-accounts, particularly those that have a high concentration in foreign issues, are an excellent risk-reduction tool that should be utilized by the vast majority of investors.
There are positive aspects to every investment. This does not mean that every investment is right for everybody. All investments also have disadvantages; there is no perfect choice. Annuities, which have been available for over 100 years, provide more features than virtually any other investment. Investors can rely on the safety of the insurance industry, with its mandated reserve requirements, financial clout, and reliance on outside rating agencies. However, annuities may not be the perfect investment. The disadvantages of annuities are few but still are to be considered. These disadvantages concern such points as potential IRS penalties and taxes, potential insurance company penalties or the ongoing expenses of variable annuities.
Advantages An annuity protects and builds a person’s cash reserve. The insurer guarantees principal,
interest, and the promise if purchased that the annuity can never be outlived. This makes the annuity particularly attractive to those who have retired and desire or requires fixed monthly income and lifetime guarantees.
There are no commission charges when an individual goes into an annuity. Stockbrokers and financial planners are well versed when it comes to annuity selections. The broker or advisor that an individual deals with is paid a commission from the insurance company.
The guarantees of safety, interest rates, and life-long income give the purchaser peace of mind and psychological security. A contract owner can terminate the contract after being in it for only a day, month, year, or decade and always be assured that the contributions are in intact.
A client can “time” the receipt of income and shift it into lower income tax bracket years. This ability to decide when to be taxed allows the annuitant to compound the advantage of deferral.
Tax-Deferred Growth is one of the chief reasons why tens of millions of people around the world are attracted to annuities. The only time that an individual pays taxes on an annuity is if he or she withdraws growth or interest from the account. For example, if someone invested $20,000 in a fixed or variable annuity and the contract was now worth $55,000, the first $35,000 taken out would be taxable; the remaining $20,000 would not be taxed since it is considered a return of principal and the IRS never taxes return of principal.
Given the same rate of interest, the annuity will produce more capital more quickly than a taxable investment because the effective yield will be higher.
The reserve requirements mean that when an individual purchases a fixed-rate annuity, the insurance company, by law, must set aside over a dollar in reserves. The insurer can only use these
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reserves to settle the withdrawals and redemptions of annuity owners. The money cannot be used
to settle insurance claims, pay overhead, settle bad debts, or take care of any other non-related annuity item. The reserve pool operates in a straightforward manner. If an insurance company goes out of business, the remaining insurers must assume the liabilities and obligations of the now defunct insurer.
Disadvantages The annual contract maintenance charge ranges from $25 to $50, depending on the variable
annuity company. The most common charge is $35 per year.
If the client is forced to liquidate the investment in the early years of an annuity, management and maintenance fees and sales costs could prove expensive. Total management fees and mortality charges can run from 1 to 2% of the value of the contract.
A long term cash flow stream of a fixed amount may not keep pace with inflation.
Receipt of a lump sum at retirement could result in a significant tax burden since income averaging is not available.
The mortality and expense fee, also known as the guaranteed death benefit, is a feature of all variable annuities; fixed-rate contracts do not possess this charge. This fee is levied against an account balance every year. The death benefit charge ranges from 1.1% to 1.5% annually, depending on the insurer and the terms of the variable annuity contract. The mortality fee is a small percentage figure based on the total value of the variable annuity. The greater the account grows, the more the insurance company will end up collecting.
With limited exceptions, 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. This means that 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.
A 10% penalty tax is generally imposed on withdrawals of accumulated interest prior to age 59 1/2 or disability. No penalty is imposed on the principal contributions when they are taken out. The 10% penalty can be avoided upon the death of the annuitant, disability of the annuitant, annuitization, or the contract owner reaches the age of 59 1/2 or older.
Tax Sheltered Annuities (TSAs), (salary reduction plans for employees of public schools and non-profit organizations),
Section 457 Plans (deferred compensation plans for public employees), and
Simplified Employee Pensions (SEPs).
Taxes and Expenses The money contributed to an annuity may be in post-tax dollars. When one contributes after-tax savings to an annuity, he can generally put in as much money as he likes. Before he puts after-tax savings into an annuity, it may be advisable for him to put the maximum pre-tax amount into a retirement plan such as his IRA, SEP, Simple 401(k) or 403(b). Also note that annuities may fund an
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IRA, SEP, Simple 401(k), 403(b) or Roth IRA. When an annuity is used to fund these vehicles there
are contribution limits that apply.
Expenses can vary. The investor should be sure that the annuity contracts he considers have competitive fees. Independent rating services such as Morningstar and Lipper Analytical Services both publish reports that compare variable annuity fees. Local libraries may have copies. While cheaper doesn't necessarily mean better, if a contract is too expensive it could offset gains from the tax-deferred status.
All earnings from annuities are taxed as ordinary income. If ones ordinary income rate at retirement is higher than the current capital gains rate for other investments, he could actually pay higher taxes. He does, however, have a tax deferral on any earnings. However, with some other investments, his estate or beneficiary may receive the unrealized gain in the investment on his death free of any federal income taxes. Also, with some other investments, he could be subject to ordinary income as well as capital gains taxes annually, even if he has not cashed in the investment, which can reduce the value of his earnings. Of course, on tax deferred earnings, taxes are due upon withdrawal and withdrawals prior to age 59 1/2 may be subject to an additional 10% tax penalty.
Client Questions Here are a few key questions the investor should ask himself before investing in an annuity:
• Have I learned all I can about annuities before purchasing?
• Have I done some comparison shopping and considered all of my options?
• Does the rate on a fixed annuity look too good to be true?
• What are the annuity’s surrender fees and how long are they in place?
• What is the track record of the funding options offered in a variable annuity?
• Does a variable annuity offer multiple funding options in case I change my investment strategy a few years down the road?
• Will my ordinary income tax rate be greater than the current capital gains rate when I begin to take distributions (possibly at retirement)?
CHAPTER NINE GGEENNEERRAALL GGUUIIDDEELLIINNEESS FFOORR IINNVVEESSTTIINNGG
Investment success is often measured by tangible returns. In reality successful investing has as much to do with the intangible—simply avoiding major errors. Here are some principles that can help agents in guiding clients in all of their investments.
* Don't invest in a stock that has been spotlighted in the news recently.
Many individuals are attracted to stocks that have received substantial media coverage. Often, however, being a media star drives up the stock price significantly. At this point one is buying a stock with a price that already embodies great expectations, with all the possible and some improbable good news already incorporated into the stock price.
* Don't hang on to a sagging stock waiting for the price to bounce back.
Some investors go to great lengths to avoid recognizing a loss that has already occurred. This may help their ego, but it won't help their performance. Holding on to a stock, no matter what the return or prospects, in the hopes of selling at the original purchase price and thereby "getting even" may entail a great opportunity cost. Instead, one should always evaluate his current holdings relative to other potential investments, and view realized losses as an opportunity to protect investment gains from taxes.
* Don't let natural disdain for paying taxes overcome one’s evaluation of the merits of continuing to hold a stock.
Some investors hold on to stocks with mediocre prospects because they do not want to sell and incur taxes on any gains. All too often, these are stocks that have already soared in value. But refusing to sell, and watching as the stock does nothing or takes a nosedive, could result in a lower return that more than offsets any taxes that would have been paid.
* Don't buy a stock because it just had a substantial drop in price.
Some investors assume that lower prices translate into bargains. Most big price drops are the result of changing circumstances at the firm. The investor should make sure he knows why a price drop has occurred before jumping to conclusions about under valuation.
* Don't buy a stock solely because you like the product the firm makes.
The product may be great but the firm may not. For instance, the product could be successful but comprise only a small portion of firm sales. Conversely, the product may be wonderful from a consumer viewpoint but a profit failure for the firm.
* Don't buy the stock of a company if unable to directly form a judgment on the prospects of the firm.
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Some companies have products and exist in markets that are technically complex and therefore difficult to evaluate by individuals not familiar with the area. If that is the case, one may be relying on the opinions of others to form his investment decision. Instead, stick to more familiar territory.
* Don't seek out high dividend yielding stocks in the belief that the higher the dividend yield, the better.
Many investors consider high dividend paying stocks to be relatively conservative investments. However, firms with extremely high dividend yields have them because they have to -- it is the market's way of telling investors that the risk of the dividend being cut or eliminated is great. One should make sure he evaluates the firm's dividend-paying history, and future prospects, when considering high dividend yielding stocks.
* Don't buy a low price-earnings ratio or low price-to-book-value ratio stock without knowing why the ratio is low.
Some investors seek stocks with low price-earnings ratios or low prices relative to book values in the belief that the market has misjudged the future prospects of a firm. However, there are risks to being a knee-jerk investor. By not seeking out the factors that pushed the price-earnings ratio down or the stock price below book value, one may end up investing in a mediocre firm in an industry in long-term decline.
* Don't inadvertently concentrate in one industry or in highly related industries.
Diversification is crucial to reducing firm and industry risk, yet many investors fail to effectively diversify by following a strategy that inadvertently concentrates their portfolio in one industry. Some individuals invest in stocks related to their work experience. But no matter how well one may select stocks, his portfolio will rise or fall with the sector's fortunes. Worse yet, his salary and employment and even the value of his home may also be tied to the economic fate of the same industry. Similarly, relying on one stock screen, such as low price-earnings ratio stocks, can inadvertently result in industry concentration.
* Don't maintain an undiversified portfolio of common stocks--one with less than 10 stocks in unrelated industries.
Diversification among various stocks in unrelated industries reduces the impact on one’s portfolio of any single investment that may turn sour. It is the most effective way to reduce risk in a portfolio without significantly reducing the long-term returns associated with investing in the stock market. Also, don't let a few stocks dominate, by value, the portfolio. If two stocks, for example, are 60% of the value of a 10-stock portfolio, one’s investments are not well diversified.
* Don't rely on "safe" stocks to reduce risk.
Many conservative investors stick with common stocks that are considered financially secure -- low debt, high liquidity, secure dividends, and conservative management. But these stocks may in the long run prove to be high risk if there are no growth prospects. It is wise to let portfolio diversification reduce the impact of reasonable financial risks and to concentrate one’s efforts on firms with the potential for significant earnings growth.
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* Don't invest in common stocks with money one may need in less than five years.
In order to take advantage of the growth in the economy and ride the positive effects of the business cycle while avoiding a forced sale at business cycle and market lows, common stock investments should be long-term commitments. While individual stocks can be moved in and out of the portfolio, liquidating the entire portfolio on a short-term basis is speculative.
* Don't move abruptly into or out of the stock market with a significant portion of one’s investment portfolio.
Because common stock investing is a long-term commitment and markets can be highly volatile, large movements in and out of the market should be made gradually. One should take at least two years to go from cash to stocks or stocks to cash with regular and even quarterly (or monthly) shifts of the funds. Dollar-cost average in and out of the market.
* Don't invest in a bond without reading and understanding the terms of the bond issue.
Before investing in a bond, one should have some idea of what may happen to the bond over the remainder of its lifetime. For instance, if he is unfamiliar with the call provisions of a bond issue, he may invest in bonds that have high income yields only to have his bonds called by the issuer a few years later when interest rates have fallen. If that occurs, and if he paid substantially above face value for the bond, he will likely sustain a capital loss when they are called, and he will be forced to reinvest the proceeds at a lower interest rate.
* Don't ignore interest rate risk.
Many investors consider bond investments to be relatively low risk, with the primary risk being the possibility of default. Investors seeking safe bond investments avoid low-rated corporate bonds and low-rated municipal bonds or invest in nothing but U.S. government securities. While default risk is minimized or eliminated, interest rate risk may be high, resulting in significant price changes. The longer the maturity of the bond and the lower the indicated coupon, the greater will be the change in market value when interest rates change. An increase in interest rates decreases bond prices, and the longer the maturity and the lower the coupon, the greater the drop in price.
* Don't buy a zero-coupon bond, including U.S. government zeroes, because one thinks it is the safest of all bond investments.
Many investors mistakenly think zero-coupon bonds, particularly U.S. government zeroes, are low-risk because they are not callable, there is no interest to reinvest, and the return is assured, in the case of a U.S. government zero, if held to maturity. In terms of interest rate risk, these bonds are in fact very risky. Long-term zero-coupon bonds dramatically fluctuate in price as interest rates change because they are long term and have no coupons. If one does not hold the bond to maturity -- and many investors don't despite their intentions otherwise -- he may be forced to sell at a time when prices have dropped significantly. Anticipating that he will hold a bond to maturity doesn't mean that he will.
* Don't buy bonds in an attempt to maintain stability of capital.
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The "bonds are safe" belief can often be shattered by inflation. Without any growth potential, bonds are reduced in value in real terms by inflation even though their nominal maturity values remain unchanged. Thus, the real value of one’s capital may not remain stable at all, but instead may steadily drop.
* Don't sell bonds before maturity without being aware of the liquidity problems in the bond market.
Other than the market for U.S. government securities, bond markets are thin, particularly for small amounts of less than $25,000 in face value. Municipal bonds can be very illiquid with virtually no secondary market for issues of only local interest. Even when quotes and buyers can be found, the bid-asked spread can be very wide and costly.
* Don't invest in anything one doesn't fully understand.
One should make sure that he knows the risks and the potential returns as well as the terms and conditions of the investment. Know what will affect the value of his investment and the likelihood of any changes in its value.
* Don't invest in only one asset category.
Diversify among categories including large stocks, small stocks, international stocks, bonds, money market investments, and real assets.
* Don't under invest in stocks if one is a long-term investor.
Many investors make the mistake of committing only a small portion, if any, of their portfolio to stocks. However, over long time periods, stocks are the only investment category that has historically provided returns that consistently out pace inflation. If one wants to protect the real value of his assets, the "conservative" investment is a healthy commitment to stocks.
* Don't be a short-term trader, switching in and out of various investments.
One will suffer at tax time, he may incur heavy transaction costs, and he will not benefit from being invested in the market over the full cycle.
* Don't invest in highly leveraged situations where he may lose substantially more than his initial investment.
These include certain futures and options strategies, as well as the use of margin.
* Don't be lured into investments promising high returns with little risk.
The potential for high returns is always accompanied by the potential for great loss, high risk.
* Don't follow anyone's "infallible system" for beating the market.
There is no such thing.
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• We have had inflation in this country since 1954 and are likely to experience it for many years to come. Therefore, we must protect the purchasing power of our income as we move into the future by making sure the returns we receive are greater than inflation, which has averaged 3.2 percent a year since 1926.
• Treasuries have only averaged 3.8 percent a year since 1926. If one subtracts the average inflation of 3.2 percent from 3.8 percent, he has an excess return of .6 percent. That means if one has $100,000 in his retirement nest egg and wishes to reinvest the percentage needed to cover inflation and spend the rest, he’ll have $600 a year for each $100,000 to cover his cost of living. That is why interest-bearing investment vehicles are said to barely keep up with inflation.
• Corporate and government bonds have averaged returns of 6.1 percent and 5.6 percent, respectively, since 1926. Again subtracting the average inflation of 3.2 percent, one would have about 2.9 2.4 to percent to support his cost of living. Using our $100,000 nest egg example above, he would have between $2,400 and $2,900 a year to spend for each $100,000 in his nest egg. The interest paid by bonds does not increase over time. It is fixed and paid every six months. Some years bonds have actually produced negative returns. The reason for the fluctuation is that if investors had sold their bonds during a negative return year to purchase stocks or Treasuries, the investors would have received less money than the bonds cost the year before. The only condition under which bonds retain their value is if investors hold them till maturity and the company or government issuing the bond is still in existence to pay investors their principal.
• Everyone knows investments in stocks can go up but can also go down. Investments in bonds can do the same. In spite of the risks in buying bonds, the potential losses in stocks are greater. The most devastating two consecutive years for the stock market were 1930-31 when the market dropped 68 percent. These were the two worst years of the Great Depression. The next two worst consecutive years were 1973-74 when the performance decline was 41 percent. If investors had remained invested for seven years after the 1930-31 decline and four years after the 1973-74 declines, they would have gotten all their money back. The average annual returns since 1926 in the S&P 500 have been 10.8 percent per year. Many say a normal market downturn is 10 percent. We haven’t had a normal market correction of 10 percent since 1974, which is why experts say we are living in the greatest bull market our country has ever known.
• Investment performances change from asset class to asset class. If one wants to achieve growth in excess of inflation, he’ll need to have at least some of his investments in stocks. The greater his need for income, the greater his need for bonds in his portfolio.
• Investing in mutual funds instead of in a narrow portfolio of individual stocks is the preferred way to invest. In years past a person could purchase a stock and pay for it, get the money to the broker within five days. Trading then progressed at a pace that seemed fast at the time but in comparison with the pace of trading today, yesterday’s trading speed was a snail’s pace. Today, a mutual fund or pension fund manager can press a key on the computer minutes before the market closes and buy or sell, not a hundred or a
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thousand shares of a stock, but several million. Lone investors holding 100 or 1,000 shares can be adversely affected by large-volume trades and find themselves waiting years to recover a loss created by a single large-volume trade initiated by a single manager.
It is best in today’s world for small investors to hire a manager to manage their money so that even the smallest investors can be part of trades of several million shares at a fraction of the cost.
CHAPTER TEN SSPPEECCIIAALL AANNNNUUIITTYY CCLLAASSSSIIFFIICCAATTIIOONNSS
Private Annuity A private annuity, in simple terms, is a contract between two parties who could, for example, be individuals, business entities or trusts. One party (called "A") transfers or sells to another party (called "B") assets having a certain value. In consideration therefore, B agrees to make payments (annually, monthly or quarterly) to A for a term of years or for A’s lifetime. The payments, if they are to pass with the Internal Revenue Service, must take into consideration the life expectancy of A if the period of payments is related to A’s lifetime (for which there are published tables) and the interest rate in the market at the time of the transaction (120% of the federal midterm rate for the applicable month or the average of the two previous months).
For Medicaid purposes, it should be explained to make sure that the value that B agrees to pay to A is equal to the values of the property sold to B by A. It is by assuring ourselves that the two values are equal (which can generally be accomplished by employing commercial software to make the calculations) that we will know that no gift from A to B has occurred. If a gift has occurred, a Medicaid ineligibility period must be calculated if A or A’s spouse needs or desires institutional care.
Benefit of Private Annuity The effect of using a private annuity is to turn a resource into a stream of income. Thus in the situation of the community spouse who has nonexempt assets in excess of $81,960, one can avoid having the community spouse owning those excess assets by using the excess assets to purchase a private annuity from a family member. Now there is a stream of income instead of excess assets. Since the community spouse is obliged to employ only 25% of income above the protected monthly income, 75% of that income can be kept and used for the living needs of the community spouse or saved.
Contributing 25% of the income generated by the increased monthly income flow may be a far better choice than having Medicaid denied or exposing to a lawsuit all assets over the protected amount. It is important to note that if the community spouse’s income does not, without counting the monthly amount generated by the private annuity, equal the monthly protected income, all of the income generated by the private annuity up to the point that the community spouse has income equal to the protected monthly income, may be kept without the need to contribute any portion toward the care of the institutional spouse. Furthermore, for many clients the thought of going through a court proceeding where the community spouse is being sued for support or on some other theory is akin to having root canal. That being said, the private annuity has the added advantage of serving as a very useful psychological elixir.
The benefits described above will not work as well outside of the marital situation. Lets say that X is 75 years of age has $50,000, no spouse to whom an exempt gift may be made, and needs institutional care in two weeks. If X gifts assets to Y, X will be subject to a period of ineligibility for Medicaid
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institutional benefits. If X does not transfer assets to Y, X will be too wealthy for the Medicaid program. If, instead of doing nothing or transferring all of the assets, X purchases from Y a private annuity, what is the result? Assuming the applicable interest rate is 6.8%, the monthly income payable to X will be $607.
Probably all of that income will be spent on X’s care. So what is the benefit? A 75 year old person has a life expectancy of approximately 10.4 years. If that person lives 50% of the actuarial life expectancy or 5.2 years, it will mean that 5.2 x 607 x 12 or $38,000 will have been paid by Y to X. $12,000 ($50,000 - $38,000) of the assets originally transferred to Y will not need to be paid X since the annuity ends with X’s death. On the other hand a different result can be obtained. X could outlive his or her life expectancy by a long period. This will mean that Y will be paying for a long time and possibly pay substantial funds to X. This could produce a financial calamity for Y.
There are some other issues of concern. With respect to the X person, who may have an illness, if it is likely that X will die in 12 months, use of the actuary tables is not permitted. On the other hand, if X lives 18 months, there is a presumption that the person has a normal life expectancy and therefore the actuary tables may be used.
For a single person facing the prospects of a nursing home a less complicated approach, often very successful, may be much better than using the private annuity. Here is how it works:
Initially determine the monthly nursing home cost. Next deduct the applicant’s monthly income to arrive at the net out of pocket cost per month to the nursing home. For example, the monthly nursing home cost is $7,500. The person entering the nursing home has combined social security and pension income of $1,500. This means that we will be required to go out of pocket $6,000 for each month the applicant is ineligible as a result of a gift of assets. Lets also say that the average monthly private cost of a nursing home in the region in which the person lives is $6,339 per month.
This means that for every $6,339 which is gifted, one month of ineligibility will be created. That one month will cost out of pocket $6,000. The total monthly expenditure will be $6,339 plus $6,000 or $12,339. We can now create a fraction as follows: 6,000/12,339 multiplied by the resources in the name of the applicant will equal the amount which must be retained to pay for that person’s cares if the applicant’s other assets are gifted. And $6,339/12,339 multiplied by the resources equals the amount which may be gifted. If you follow this approach, the penalty period created by the transfer will be paid for by the resources retained.
Gift Annuities A charitable gift annuity is an irrevocable contractual arrangement made between an individual and a charitable organization. It provides the donor and/or another annuitant an annual fixed income for life in exchange for the transfer of property, usually cash or marketable securities to the organization. There is no “trust” underlying the arrangement which is considered part gift and part purchase of an annuity under contract.
The organization assumes the payment as a general obligation through the pledge of its entire assets. It also assumes the financial risk of the investment. The age of the beneficiaries and administrative
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costs therefore must be factored into the equation. The organization should end up with at least fifty percent of the contributed principal as a remainder at the time of death of the last income beneficiary.
Deferred charitable gift annuities are those in which the annuitant defers the receipt of income to a specified date at least one year in the future, but realizes an immediate federal income tax charitable deduction. Deferred charitable gift annuities are ideal for individuals who have no need for immediate income but may desire supplemental retirement income at a later date.
The federal income tax charitable deduction is determined from actuarial tables based upon the number of annuitants, their ages, and the “Charitable Mid-term Federal Rate.” Computations are based on the assumption that a portion of the gift principal is used to make annual payments.
The charitable gift annuity arrangement is an excellent way to provide immediate contribution to a non-profit organization while providing a secure source of income for the participant.
The charitable gift annuity allows the participant to:
• Choose the rate of return on the funds invested
• Provide an immediate gift to a non-profit organization
• Receive a tax deductible receipt for the gift amount
• Receive a portion of the annuity payment tax free
• Direct any remaining payments upon the annuitant's death to the non-profit organization
The charitable gift annuity is ideally suited for individuals who are at least 60 years of age, in reasonably good health, and who have other sources of income, other than what would be provided by this annuity.
Using the charitable gift annuity the annuitant has the opportunity to determine the annual rate of return (s) he desires on his/her investment. For example, by selecting a 10% rate of return on an investment of, say, $12,000 the annuitant would receive a monthly payment of $100 as long as (s)he lived. Depending on the annuitant's age, interest rate chosen, and external market interest rates at the time of annuity purchase, an organization would receive a donation for which the annuitant would receive a tax deductible receipt.
Since the annuity would be purchased with "after tax dollars" a portion of the payments received from the annuity would be received on a tax-free basis. The amount of the tax-free portion varies with the participant's age.
Railroad Employee Annuities The basic requirement for a regular employee annuity is 120 months (10 years) of creditable railroad service. Service months need not be consecutive, and in some cases military service may be counted as railroad service.
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Credit for a month of railroad service is given for every month in which an employee had some compensated service for an employer covered by the Railroad Retirement Act, even if only one day's service is performed in the month. However, local lodge compensation earned after 1974 is disregarded for any calendar month in which it is less than $25. Under certain circumstances, additional months of service may be deemed.
Covered employers include railroads engaged in interstate commerce and certain of their subsidiaries, railroad associations and national railway labor organizations.
Railroad retirement benefits are based on months of service and earnings credits. Earnings are creditable up to certain annual maximums on the amount of compensation subject to railroad retirement taxes.
Age and Service Annuity An Age and Service Annuity can be paid to:
Employees with 30 or more years of service. They are eligible for regular annuities based on age and service the first full month they are age 60. Early retirement reductions are applied to annuities awarded before age 62.
Employees with 10 to 29 years of creditable service. They are eligible for regular annuities based on age and service the first full month they are age 62. Early retirement annuity reductions are applied to annuities awarded before age 65.
Starting in the year 2000, the age at which full benefits are payable increases in gradual steps until it reaches age 67. This affects people born in 1938 and later. Reduced annuities will still be payable at age 62 but the maximum reduction will be 30% rather than 20% by the year 2022. Part of an annuity is not reduced beyond 20% if the employee had any creditable railroad service before August 12, 1983. These reductions do not affect those who retire at age 62 with 30 years' service but will affect those who retire at ages 60-61. Benefits are increased for each month an employee delays retirement past full retirement age, currently 65, up until age 70.
An annuity based on age cannot be paid until the employee stops railroad employment, files an application and gives up any rights to return to work for a railroad employer.
Disability Annuity If an annuity is based on disability, there are certain work restrictions that can affect payment, depending on the amount of earnings. The annuity is not payable for any month in which the annuitant earns more than $400 in any employment or self-employment, exclusive of work-related expenses. Withheld payments will be restored if earnings for the year are less than $5,000 after deduction of disability-related work expenses. Otherwise, the annuity is subject to a deduction of one month’s benefit for each multiple of $400 earned over $4,800 (the last $200 or more of earnings over $4,800 counts as $400). Failure to report such earnings could involve a penalty charge.
These disability work restrictions cease upon a disabled employee annuitant’s attainment of full retirement age, currently age 65, when the annuitant becomes subject to the work and earnings
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restrictions applicable to employee annuities based on age and service. This transition is effective no earlier than full retirement age even if the annuitant had 30 years of service.
If a disabled annuitant works before full retirement age, this may also raise a question about the possibility of that individual’s recovery from disability, regardless of the amount of earnings. Consequently, any earnings must be reported promptly to avoid overpayments, which are recoverable by the Board and may also include penalties.
Supplemental Annuity A supplemental annuity can be paid at:
• Age 60, if the employee has at least 30 years of creditable railroad service.
• Age 65, if the employee has 25-29 years of railroad service.
In addition to the service requirements, a "current connection" with the railroad industry is required for all supplemental annuities. Eligibility is further limited to employees who had some rail service before October 1981.
Current Connection Requirement An employee who worked for a railroad in at least 12 months in the 30 months immediately preceding the month his or her railroad retirement annuity begins will meet the current connection requirement for a supplemental annuity, occupational disability annuity or the survivor benefits described later in this booklet. (If the employee died before retirement, railroad service in at least 12 months in the 30 months before death will meet the current connection requirement for the purpose of paying survivor benefits.)
If an employee does not qualify on this basis, but has 12 months’ service in an earlier 30-month period, he or she may still meet the current connection requirement. This alternative generally applies if the employee did not have any regular employment outside the railroad industry after the end of the last 30-month period which included 12 months of railroad service and before the month the annuity begins or the date of death. Full- or part-time work for a non railroad employer in the interval between the end of the last 30-month period including 12 months of railroad service and the beginning date of an employee's annuity, or the date of death if earlier, can break a current connection.
Self-employment in an unincorporated business will not break a current connection; however, self-employment can break a current connection if the business is incorporated.
Working for certain U.S. Government agencies--Department of Transportation, National Transportation Safety Board, Surface Transportation Board (the former Interstate Commerce Commission), National Mediation Board, Railroad Retirement Board--will not break a current connection. Neither State employment with the Alaska Railroad, so long as that railroad remains an entity of the State of Alaska, nor non-creditable Canadian railroad service will break a current connection.
A current connection can also be maintained, for purposes of supplemental and survivor annuities, if the employee completed 25 years of railroad service, was involuntarily terminated without fault
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from the railroad industry, and did not thereafter decline an offer of employment in the same class or craft in the railroad industry regardless of the distance to the new position.
A termination of railroad service is considered voluntary unless there was no choice available to the individual to remain in service. Generally, where an employee has no option to remain in the service of his or her employer, the termination of the employment is considered involuntary, regardless of whether the employee does or does not receive a separation allowance. However, each case is decided by the Board on an individual basis. This exception to the normal current connection requirements became effective October 1, 1981, but only for employees still living on that date who left the rail industry on or after October 1, 1975, or who were on leave of absence, on furlough, or absent due to injury on October 1, 1975.
Once a current connection is established at the time the railroad retirement annuity begins, an employee never loses it no matter what kind of work is performed thereafter.
Spouse Annuities The age requirements for a spouse annuity depend on the employee’s age and date of retirement and the employee’s years of railroad service.
If a retired employee with 30 years of service is age 60, the employee’s spouse is also eligible for an annuity the first full month the spouse is age 60. Certain early retirement reductions are applied to such a spouse annuity if the employee retires before age 62, unless the employee attained age 60 and completed 30 years’ service prior to July 1, 1984. If a 30-year employee retires at age 62, an age reduction is not applied to the spouse annuity even if the spouse retires at age 60 rather than age 62, unless the employee retired on the basis of disability.
If a retired employee with 10-29 years of service is age 62 (or age 65 if the employee’s annuity began before 1975), the employee’s spouse is also eligible for an annuity the first full month the spouse is age 62. Early retirement reductions are applied to the spouse annuity if the spouse retires prior to age 65. Beginning in the year 2000, full retirement age for a spouse will gradually rise to age 67, just as for an employee. Reduced benefits will still be payable at age 62, but the maximum reduction will be 35% rather than 25% by the year 2022. Part of a spouse annuity is not reduced beyond 25% if the employee had any creditable railroad service before August 12, 1983. A spouse of an employee receiving an age and service annuity is eligible for a spouse annuity at any age if caring for the employee's unmarried child, and the child is under age 18 or the child became disabled before age 22.
The employee must have been married to the spouse for at least one year, unless the spouse is the natural parent of their child, the spouse was eligible or potentially eligible for a railroad retirement widow(er)’s, parent’s or disabled child’s annuity before marrying the employee or the spouse was previously married to the employee and received a spouse annuity. However, entitlement to a surviving divorced spouse, surviving divorced young mother (father), or remarried widow(er) annuity does not waive the one-year marriage requirement.
An annuity may also be payable to the divorced wife or husband of a retired employee if their marriage lasted for at least 10 years, both have attained age 62 for a full month and the divorced spouse is not currently married. The amount of a divorced spouse’s annuity is, in effect, equal to
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what social security would pay in the same situation and therefore less than the amount of the spouse annuity otherwise payable.
Employee and Spouse Annuity Estimates Because of the complexities of the railroad retirement laws and the need for lifetime earnings records, it is generally not practical for an employee to attempt to estimate his or her own regular annuity or the annuity of the spouse. Employees who want estimates should contact the nearest field office of the U.S. Railroad Retirement Board for approximate figures. Each Board field office can furnish estimates for employees with at least 10 years of railroad service.
Railroad Retirement Maximum The maximum reduction is generally applied to the initial award, and that reduced amount receives all applicable subsequent cost-of-living increases.
The maximum increases every year as the amounts of creditable earnings rise. Therefore, an employee with high recent earnings who is affected by the maximum can still gain larger benefits by continuing work after his or her earliest eligibility date.
The maximum provision may also affect certain long-service employees as well as those with low earnings, or no earnings, in the 10-year period ending with the year the employee’s annuity begins. An example of someone with low earnings could be an employee who accepted a separation allowance and then worked part-time social security covered jobs until retirement. Cases with no earnings could include Canadian employees whose coverage under the Railroad Retirement Act ceased after December 31, 1982, and who had no subsequent creditable earnings under the Railroad Retirement or Social Security Acts. Cases with no earnings could also include persons working in non-covered Federal jobs.
Working After Retirement Neither a regular annuity, a supplemental annuity nor a spouse annuity is payable for any month in which a retired employee works for a railroad employer, including labor organizations (exception regarding local lodge employees).
The Tier I and vested dual benefit components of employee and spouse retirement annuities may be subject to certain limitations based on any earnings outside the railroad industry. Tier I and vested dual benefit components are subject to deductions if earnings exceed the exempt amounts applicable to social security beneficiaries. The deduction is $1 in benefits for every $3 earned over the exempt amount in a calendar year for those between full retirement age (currently 65) and 69; for those under full retirement age, it is $1 in benefits for every $2 of earnings. An employee’s earnings over the exempt amount may also reduce the spouse benefit.
Earnings consist of all wages received for services rendered plus any net earnings from self-employment. Interest, dividends, certain rental income or income from stocks, bonds, or other investments are not generally considered earnings for this purpose. Annual earnings in 2005 up to $31,800 for those ages 65-69 and $12,000 for those under age 65 are exempt from work deductions. No deduction is made in either the Tier I or vested dual benefit component for any month beginning with the month in which the annuitant attains age 70.
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In the first year in which an employee is both entitled to an annuity and has a non-work month, a full annuity can be paid for those months in which the employee had low earnings or did not have substantial self-employment, no matter what total earnings for the year were. A non-work month is one in which the employee neither earns over the monthly exempt amount nor has substantial self-employment. Otherwise, work deductions are based on annual earnings, whether or not the annuitant worked in every month and regardless of the amount of earnings in a particular month.
Annuitants who work after retirement and expect that their earnings for a year will be more than the annual exempt amount must promptly notify the Board and furnish an estimate of their expected earnings in order to prevent an overpayment and penalties. They should also notify the Board if their original estimate changes significantly.
Retired employees and spouses who work for their last pre-retirement non railroad employer are subject to an additional earnings deduction. Such employment will reduce Tier II benefits and supplemental annuity payments, which are not otherwise subject to earnings deductions, by $1 for each $2 of compensation received, subject to a maximum reduction of 50%.
The deductions in the Tier II benefits and supplemental annuities of individuals who work for pre-retirement non-railroad employers apply even if earnings do not exceed the Tier I exempt earnings limits. Also, while Tier I and vested dual benefit earnings deductions stop when an annuitant attains age 70, these Tier II and supplemental annuity deductions continue to apply after the attainment of age 70. Retired employees and spouses must therefore promptly notify the Board if they return to work for their last pre-retirement non-railroad employer.
A spouse benefit is subject to reductions not only for the spouse's earnings, but also for the earnings of the employee, regardless of whether the earnings are from service for the last pre-retirement non-railroad employer or other post-retirement employment.
Earnings of $25 or more a month by a local lodge employee will prevent payment of the annuity for that month. A spouse annuity is not payable for any month in which the employee's annuity is not payable, or for any month in which the spouse works for a railroad employer or railroad union.
When Annuities Stop Payment of any annuity stops upon the annuitant's death, and the annuity is not payable for any day in the month of death.
A disability annuity stops after the employee recovers from the disability; it can be reinstated if the disabling condition recurs.
A spouse annuity stops if the employee's annuity terminates, or the spouse annuity was based on caring for a child and the child is no longer under 18 or disabled or the child is no longer in the spouse's care (but the spouse annuity may continue if she or he is qualified without the child or it can resume when the spouse attains a qualifying age).
While a divorce ends eligibility for a spouse annuity, a divorced spouse may, under conditions described previously, qualify for a divorced spouse's annuity.
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A divorced spouse’s annuity stops upon remarriage or upon entitlement to a social security benefit, based on her or his own earnings, if the unreduced social security benefit is equal to or greater than one-half of the employee’s unreduced tier I amount.
It is important to notify the Railroad Retirement Board promptly if one of the above changes occurs. Failure to report can result in an overpayment, which the Board will take action to recover, sometimes with interest or penalties. Failure to report changes promptly or making a false statement can also result in a fine or imprisonment.
Grantor Retained Annuity Trust (GRAT) A GRAT is somewhere between a revocable trust (where one pays no gift taxes but pays hefty estate taxes later on) and an irrevocable trust (minimizes estate taxes). Suppose one has $3 million in tax-exempt municipal bonds with a 5 percent interest rate. The investment brings in $150,000 per year, but one’s living expenses are only $50,000 per year. If the person dies holding the money, Uncle Sam gets about half. By creating a GRAT, he effectively gets the money out of his estate. He can set an amount that he’ll receive each year from the trust. He can still manage the trust and buy or sell the stocks or funds now owned by the trust. Like a qualified personal residence trust (QPRT), one chooses a term for the trust. Because he is taking money out of the trust and his family doesn’t get it outright, the present value of the gift is discounted by the IRS, so less gift tax is due.
AANNNNUUIITTIIEESS AANNDD MMEEDDIICCAAIIDD Using annuities to protect assets from the nursing home expense has become very popular. Two recent books on the subject, The Medicaid Planning Handbook by Alexander A. Bove, Jr. and Avoiding the Medicaid Trap by Armond Buddish, specifically discuss the use of annuities to avoid Medicaid seizure. In fact, two insurance companies have designed deferred annuity products with features that are implemented at the appropriate time to get around Medicaid rules.
The recent passage of the Kennedy Kassebaum Bill firmly establishes annuities as a viable tool to protect assets from Medicaid spend down. Why annuities? An annuity is unique in that a deferred annuity can be annuitized or converted from an asset form to an income form like a guaranteed pension. This can be a lifesaver if one exceeds the Medicaid asset test limit. Converting the asset to income can sometimes enable the applicant to pass the asset test.
Another use is with the immediate annuities where funds are placed in an immediate annuity, thereby instantly converting assets to income. Although using annuities in this manner may be beneficial in the right situation if structured properly, there are many potential disasters with using annuities to shield assets:
Annuities as a Shield Many states’ rules for Medicaid differ greatly. It is important to learn as much as possible about one’s own state’s specific rules. The annuity must be annuitized prior to applying for Medicaid. Many consumers who own deferred annuities will not remember that they must annuitize the policy prior to applying for Medicaid. Once the Medicaid applicant reveals that their annuity is a deferred annuity, then it’s too late. Medicaid (Social Services) will order the policy owner to either cash in the annuity for spend-down or simply disqualify the applicant for having assets that exceed the qualifying amount.
If one purchases an annuity for the purpose of protecting his money from nursing home spend down, there is no guarantee that Medicaid will not simply change their qualification rules in order to disqualify such Medicaid applicants. The government is an expert at changing the rules.
Under the Kennedy Kassebaum and OBRA ’93 Act, an annuity must have life expectancy payout rates that are in accord with the latest social security mortality tables. Many insurance companies’ payout rates are not in compliance.
Some annuities will not allow one to annuitize the first year. Therefore, if his situation should require annuitization during the first year, he would simply be out of luck! (There are other annuities that will not allow annuitization for 5-15 years.)
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If a deferred annuity is purchased to shield assets against Medicaid, the purchaser will often make a spouse the annuitant, so that in the event of nursing home confinement, the deferred annuity can be annuitized with income going to the spouse. However, if the annuitant predeceases the annuity owner, the death benefit is triggered. In some cases, a surrender charge is charged upon the death of the annuitant. In addition, the owner of the annuity will receive notice from the IRS for the taxable gain, not a pleasant experience. Finally, since the spouse is usually the primary beneficiary, the proceeds will be made payable to the contingent beneficiary. This is most likely the children and not the owner of the policy. This scenario could cause exercise of one’s E&O.
Many purchasers do not understand how Medicaid actually works and therefore are not qualified to engage in this type of planning. OBRA 93 established and mandated a 60-month look back for deferred annuities. Many State Medicaid offices use this provision to initiate or trigger the ineligibility penalty period, creating an array of problems that may ultimately be attributable to ownership of a deferred annuity.
Using an annuitized annuity to shield assets loses its glitter when it comes to single individuals, since the annuitized income cannot be directed to another individual as with married couples and the income stops should the income recipient die.
What happens when the annuitant simply dies? One cannot attempt to qualify for Medicaid by annuitizing his policy with the intention of passing excessive monies to his heirs. Under the Estate Recovery rules passed by OBRA 93, any income that continues to heirs after one’s death could be subject to recovery by Medicaid.
It is worth considering that if one annuitizes based on his life expectancy, the interest rate provided by the company may be quite low. If the annuity owner has to enter a nursing home because he has become incapacitated or mentally incompetent, who can make the decision to either gift the annuity policy or simply annuitize it? No one can, unless there is a durable power of attorney which grants such power. Even having a durable power of attorney is no guarantee, since many documents do not contain the requisite language for gifting or annuitizing such a policy.
Anyone considering the purchase of an annuity to shield their assets from Medicaid needs to do so very carefully. Here are some guidelines for investing wisely and protecting one’s Medicaid benefits:
• Only purchase annuities that allow annuitization based upon the life expectancy factors of SSI. Many departments of Social Services (the arm of HCFA that administers Medicaid) will not permit a payout annuity that uses different life expectancy factors.
• The applicant and his or her spouse should apply as Joint Annuitants. If either one has to enter a nursing home, the company can simply drop the other annuitant.
• Only purchase deferred annuities that will allow the annuitant to annuitize in the first year, since most deferred annuities will not allow annuitant to annuitize within the first year should the annuitant become nursing home bound within the first year. This would not apply if he uses an immediate annuity.
• Most annuity contracts are "owner friendly" as opposed to "annuitant friendly." Work with annuitant-driven contracts. While purchasing an immediate annuity can be an
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effective Medicaid estate planning tool, proper care must be exercised as this approach also carries the risk of creating serious problems. The theory behind using an immediate annuity is this: By using assets to purchase an immediate income annuity for either the individual or the remaining spouse, assets leave the estate in such a manner that current OBRA rules are satisfactorily navigated and the patient will qualify for Medicaid. However, without proper planning, there is a real danger that the income stream from the annuity could put the annuitant over the income limit that allows them to qualify for benefits. If this happens, the individual could be putting himself in a serious bind.
• Consider the following example. An individual wants to reside in a nursing home that costs $2,500 per month. In order to pass Medicaid qualification tests, he must use a significant portion of his assets to purchase an immediate fixed annuity that pays $1,200 per month for life. His only other income, from Social Security, is $525, making the monthly income total $1,725. However, in order to qualify for Medicaid, monthly income must be less than the federal limit of $1,561 (2005).
• An investor should be told at point of sale to get in touch with his agent immediately should he require nursing home confinement., It may require him to cash out, annuitize, change annuitants, etc. prior to confinement.
• It is wise for the seller of annuities to work with a qualified Elder Law Attorney. It is critical that he learn what the key issues are and fully understand the use of annuities in Medicaid planning.
Immediate Annuity AS Qualification for Medicaid The phrase "Medicaid estate planning" describes various methods that attorneys, financial planners and insurance agents use to manage, shield, transfer, or dispose of clients’ assets so that they will be able to qualify for long term health care under the federal program known as Medicaid.
According to the Medicaid eligibility rules, one now has too much money coming in. In the process of clearing out much of his assets, he has established a guaranteed income that is too high and that he has no way of reducing. Even worse, this amount of income very likely won’t be sufficient to cover the cost of his current medical expenses. In short, not only has he failed to qualify for Medicaid coverage, he has also locked himself into a situation in which his current income is not enough to meet the medical expenses that he alone is obligated to pay.
Using Annuities to Shelter Non-exempt Assets Assets of a married couple that exceed the community spousal resource allowance, and income in excess of the minimum monthly maintenance needs level, must be disposed of if the sick spouse is to become eligible at an early date for Medicaid benefits. Practitioners often find that good cause exists for obtaining a court-ordered increase of the minimum monthly maintenance needs level. Realistic needs of the well spouse should be examined to determine if this strategy is possible. Asset spend-down is available, but is not very attractive to the proponent of wealth preservation unless the expenditure is used to increase the value of an exempt asset.
The annuity has become a more appealing approach. There are many annuities planning options, which need to be analyzed for their relative advantages and disadvantages. The tax impact of liquidating assets to convert them to an annuity must be evaluated as well.
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Medicaid guidelines for the use of annuities, which clarify OBRA ’93, have been published by the Health Care Financing Agency. Under these guidelines, annuities must not be guaranteed for a period longer than the actuarial life expectancy of the annuitant (either the institutionalized individual or the community spouse). If they are, the payments that are guaranteed to be made later than the end of the actuarial life expectancy represent a transfer and will be penalized as such when the annuity is established. To avoid transfer penalties, guarantee periods of annuities must take into account the new guidelines concerning actuarial life expectancies.
In Medicaid planning, deferred annuities are generally avoided because they are at the greatest risk of being considered an available asset under the new rules. Consequently, immediate annuities (under which a client’s funds are transferred to an insurance company in exchange for the promise of a stream of future periodic payments) are the type of annuity most often selected in Medicaid planning.
Types of Annuities There are several kinds of immediate annuities, not all of which make payments for life. But all immediate annuities provide for periodic payments that are predetermined and specified when the contract is negotiated. Payments are made at various set intervals at least once each year, and any one contract must last for a period greater than one year.
Immediate annuities are usually irrevocable contracts. Once the annuity has been purchased, the owner does not have the right to revoke the contract and obtain a refund (except for a "free-look" period of usually the first 30 days after purchase), irrevocable annuities are necessary for the Medicaid planning approaches discussed in this article. Immediate annuities are afforded tax advantages in that a portion of each payment is treated as a return of capital while the balance is considered a payment of interest. Types of immediate annuities include the following:
Life Only Immediate Annuities This is an annuity under which the insurer promises to make periodic payments to the beneficiaries for the life of the annuitant. This kind of annuity produces the largest periodic payment among annuities that are guaranteed and continue for the life of the annuitant. No provision is made for heirs because the contract terminates on the death of the annuitant, and all remaining principals is retained by the insurance company. Accordingly, a substantial loss is incurred if the annuitant dies early. As a result, this type of annuity is used most often by clients who require higher, guaranteed payments for the rest of their lives and are comfortable invading principal while they are alive. For Medicaid planning purposes, "life only" annuities are generally advisable only in the case of a married couple who have no heirs or whose heirs have been given other assets.
Life Annuities with Refund Provisions Providing for heirs becomes possible if the annuity contract is for a period certain (continuing for the greater of the life of the annuitant or a stipulated time period), or if it provides for a refund (guaranteeing total annuity payments at least equal to the premium received by the company). To qualify under the Medicaid guidelines, the period of the guarantee cannot be longer than the actuarial life expectancy of the annuitant.
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Period Certain Annuities These annuities have no life component. The period of the annuity payments is predetermined and does not depend on the survival of the annuitant. The payment is guaranteed and will be made either to the original beneficiary or, in the event of the original beneficiary’s death, to contingent beneficiaries named in the policy. Therefore, the owner is assured of no loss in the value of his estate due solely to an early death. Under OBRA ‘93, the guarantee period must be no greater than the stated actuarial life expectancy.
Staged Annuities Payments under this kind of annuity — instead of being level — are structured to increase at some agreed upon rate, resulting in lower payments in the earlier years and higher payments later. The structure is determined after taking into consideration share of cost aspects, anticipated changes in other income, special needs, and life expectancy.
Examples of the effectiveness of a staged, period certain annuity demonstrate the creative Medicaid planning techniques available:
Example. A single individual (female, age 85) has a realistic life expectancy of less than five years although her actuarial expectancy is more than six years. She owns $100,000 of excess assets (i.e., in excess of the limits permissible to qualify for Medicaid). The annuitant purchases a $100,000 annuity for five years certain, with monthly payments of $490 and a final lump-sum payment of $95,000. The client qualifies for Medicaid because the annuity is an unavailable asset, but in case of death during the annuity period, her heirs will receive the remaining payments as well as the final payment of $95,000.
Example. A married couple own $20,000 in excess assets. The institutionalized spouse (male, age 82) has income of $1,300 per month, and the community spouse (female, age 78) has a monthly income of $400. The couple purchase a period certain annuity that pays $150 per month for a five-year period certain plus a final payment of $15,000. This arrangement allows Medicaid eligibility for the institutionalized spouse while permitting allocation of the institutionalized spouse’s excess income to the community spouse in order to keep within the monthly minimum maintenance needs allowance. Again, under OBRA ’93 guidelines, the guarantee period of the annuity must be no greater than the stated actuarial life of the annuitant.
Variable Annuities Variable annuities provide one with a diversified group of professionally managed portfolios, similar to mutual funds. The owner has the flexibility of allocating his money among one or more of these portfolios. As his financial objectives change, he can reallocate his assets tax-free. In fact, some variable annuity programs have an asset allocation program that automatically repositions ones assets according to market cycles, changes in the economy and his personal risk tolerance. Like mutual funds or individual stock and bond investments, variable annuities do not offer guaranteed principal or a specific rate of return.
However, unlike any other investment available today, in the event of one’s death, variable annuities can offer the beneficiaries a guaranteed return, regardless of market performance. And, variable annuities provide an opportunity to participate in the high potential returns of the stock and bond markets. Although one will also take on a degree of investment risk, the long-term nature of variable annuities allows him to "ride out" short-term market fluctuations. History has proven that over time, stocks and bonds provide higher returns than many other investments.
Finally, depending on the variable annuity one chooses, in the event of his death, beneficiaries may be guaranteed as much as a 7 percent return. Of course, they will receive the market value of his investment if it is greater than the guaranteed value.
The closer one comes to retirement, the more important it is to take advantage of investments that offer tax-deferred growth. Thanks to the tax-deferred compounding feature of fixed and variable annuities, one’s retirement nest egg grows faster while his financial future becomes more secure.
Fixed Annuities Taxed Deferred Growth Perhaps the most powerful tool of an annuity is the control that it gives one over his taxes. With an annuity the income tax on interest earnings is deferred until one chooses to access his savings. By deferring the tax he can immediately realize a decrease in his federal and state income tax. With no current taxation one earns:
• Interest on principal.
• Interest on interest
• Interest on the money that would have been paid in taxes
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Tax Reduction With respect to the recent tax revisions on social security tax, reduction is made possible by realignment of municipal bonds and other investments into annuities. With qualified plans, i.e., IRA's, SEP's, Keogh's, one is reducing his pre-taxed income by contributing to the plans in the form of flexible (FPDA) annuities.
Tax Advantages One pays no taxes while his money is compounding. He can also pay a lower tax on random withdrawals because he controls the tax year in which the withdrawals are made, and only pays taxes on the interest withdrawn. Tax-deferral gives him control over an important expense - his taxes. Any time he controls an expense, he can minimize it. The longer he can postpone this particular expense, the greater his gain when compared to the gain he would make with a fully taxable account.
Tax-Deferred Advantage To illustrate the increased earnings capacity of tax-deferred interest, compare it to fully-taxable earnings. $25,000 at 6.0% will earn $1,500 of interest in a year. A 28% tax bracket means that approximately $420 of those earnings will be lost in taxes, leaving only $1,080 to compound the next year. If these same earnings were tax-deferred, the full $1,500 would be available to earn even more interest. The longer one can postpone taxes, the greater the gain.
One’s tax-deferred annuity is safe. A qualified legal reserve life insurance company is required to meet its contractual obligations to the investors. These reserves must, at all times, be equal to the withdrawal value of one’s annuity policy. In addition to reserves, state law also requires certain levels of capital and surplus to further increase policyholder protection. Legal reserve refers to the strict financial requirements that must be met by an insurance company to protect the money paid in by all policyholders. These reserves must at all times, equal to the withdrawal value (principal plus interest less early withdrawal fees, if any) of every annuity policy. State insurance laws also require that a life insurance company must maintain certain minimum levels of capital and surplus, which provide additional policyholder protection.
Withholding Tax There is no withholding tax while the annuity is compounding; it is completely tax-deferred. If one requests a distribution (random withdrawals or annuity income), taxes will be withheld – unless he elects differently. His election not to withhold can be made at the time he makes his request. Because the interest is tax-deferred, it is not necessary to issue a Form 1099 while the money is compounding. Only when the interest is distributed (withdrawal or annuity income) will a Form 1099 be sent, reflecting the amount of interest actually received.
Tax Sheltered Annuities A Tax Sheltered Annuity program, 403b, is a retirement savings plan designed specifically for payroll deduction contributions of employees of public educational institutions and certain non-profit organizations. Each deduction from one’s paycheck reduces his federal taxable income and he is sheltered from federal income taxes until he retires and starts making withdrawals. Some states also recognize the deduction and allow investors to reduce their state taxable income by the same
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amount. Each state differs so one should check with the revenue department in your state of residence.
Reduces Taxable Income The amount of money one elects to have deducted from his paycheck reduces his federal taxable income. For example; if his income reported by his employer on his W-2 statement at the end of the calendar year was $30,000 and he elected to contribute $100.00 a month to his Tax Sheltered Annuity, his W-2 income would be reported as $28,000. This means that his federal taxes would be calculated on $28,800 not $30,000 and he would have contributed $1,200 to his TSA.
Special Provisions Generally, the maximum annual contribution that one may deduct from his salary is the lesser of 100% of his gross income not to exceed $14,000 (2005). This new amount under the Economic Growth & Tax Reform Reconciliation Act of 2001. Prior to this law, this amount was also known as the Maximum Exclusion Allowance. The formula was used to determine one’s Maximum Exclusion Allowance and took into account his salary, the number of years he has been employed, prior contributions to TSA's and other "qualified" plans.
In addition to the old Maximum Exclusion Allowance calculation there was also a "Catch-Up Provision". This provision was available to those who had been employed by the same employer for 15 years or longer and the maximum contribution under that provision was $12,500. Under the new law, the “catch up” provision for those age 50 and older is $4,000 (2005). The deposit maximum and “catch up” amounts will each increase by $1,000 to $15,000 and $5,000 respectively for 2006 and then the deposit maximum “only” will increase into the future automatically by the CPI in $500 increments.
The IRS allows one to change the dollar amount of his contributions at any time during the year. This allows one to either increase or decrease his contribution to suit his needs and objectives.
Distributions are subject to a 10% penalty tax unless one:
• Has reached the age of 59 1/2,
• Has become disabled, retired
• Or terminate his employment after the age of 55.
When one begins making withdrawals the amount withdrawn in that calendar year is subject to federal income taxes. It is assumed that when one retires he will be in a lower tax bracket.
The IRS allows one to borrow money from his TSA tax free. He may take a loan from his TSA to buy a car, a child’s education, or for any reason at any time and maintain the tax-favored status of his account. The IRS requires that he repay the loan over a period of not more than five years and he must make payments not less than quarterly.
The annuitant owns and controls the assets in his TSA. He selects the amount of his contributions within limits of the law. He selects the investment vehicles where he wants his money invested and he determines what "risks" he is willing to take.
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Investment Vehicles The IRS has approved the use of three general types of investment vehicles for tax sheltered annuities. They include
• Annuities and index annuities issued by insurance companies
• Mutual Funds
• Variable Annuities
• Life Insurance.
Depending upon one’s financial objectives and his investment comfort level a combination of one or more of the products may be used in his TSA.
TSA Account After one decides how much money he would like to have deducted from his paycheck, he completes a "Salary Reduction Agreement" which authorizes his employer to deduct contributions from his paycheck and transfer them to his TSA account. Next he opens a TSA Account by completing an application for a mutual fund, variable annuity, fixed annuity or indexed annuity. Then he takes the "Salary Reduction Agreement" signed by his employer, the TSA application signed by himself and mails both forms to the issuer of the TSA product.
Social Security Under current tax law, Social Security benefits are taxed up to 85 percent for many Americans. This percentage is based on ones amount of investment income. During the years one is funding his annuity, income and capital gains earned from the annuity are exempt from Social Security tax calculations. After he begins making withdrawals, only a portion of his annuity income would be included in the calculation. For example, over a five-year period only 15 percent of annuity income has a bearing on Social Security taxes.
Summary One of the best ways to take advantage of tax-deferred programs designed to help build wealth for a comfortable retirement is through an annuity investment. IRAs and qualified plans like 401(k)s are fine, but they limit one’s annual contributions. If one wants to invest more money for his retirement years, annuities may be the answer.
Like most life insurance industry products, annuities can be confusing. Stripped down to its essentials, an annuity is a tax-sheltered investment sponsored by an insurance company that pays one earnings and also has a death benefit. Generally, when the investor buys an annuity, he hands over a lump of money – ranging from $2,000 to $10,000 or more – to a stockbroker, insurance agent, or financial planner. This salesman then passes the money along to a life insurance company, which in turn issues the annuity contract.
The Contract Some insurers let the investor buy a flexible-premium retirement annuity through regular periodic payments, sometimes for as little as $25 a month. In either case, the insurer agrees to pay the holder of the annuity contract a certain amount of money at a certain date; if the contract holder dies while owning the annuity, the beneficiary that he has named will receive a death benefit. Just as with an Individual Retirement Account, the income that one’s money earns grow tax-free until he makes a withdrawal from the annuity. Unlike an IRA, though, the annuity contributions are unlimited.
When the owner is ready to withdraw his money, he has three options. He can
• Pull all his money out
• Withdraw a little at a time
• Annuitize
The latter simply means that he can convert the account’s value into a monthly income stream that can run for a period he selects, typically the rest of his life.
He doesn’t need to annuitize with the same insurance company that sponsored his annuity; he can switch to a different company offering a better deal. However one decides to receive his cash, he’ll owe income tax on the earnings when he gets them, at whatever tax bracket he happens to be in at the time. If he takes the money out of the annuity before he reaches age 59 ½ he will also have to pay a 10% tax penalty for early withdrawal.
Front-End Fees By and large, there are no front-end fees on annuities. The salesman’s commission which ranges from 4% to 7% is factored into the annuity’s interest rate and one’s payout. Annuities come with hidden annual fees, however, which can easily total 2% a year. That’s almost a full percentage point more than the fees on an average mutual fund bought through a tax-sheltered IRA or 401(k). Most annuities also charge sizable fees for substantial withdrawals. These surrender charges are as high as 15% of one’s accumulated earnings for a withdrawal made in the first year of the contract. After that, the charges drop by about one percentage point each year until they disappear, typically in about
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seven to ten years. Many insurance companies, let investors withdraw 10% of their account’s value each year without incurring any penalty.
Types Immediate-Pay Sometimes called lifetime annuities this type is purchased with a lump sum, typically by people in retirement who want to provide a guaranteed stream of income for themselves. One might get the lump sum from his pension plan distribution, IRA, or Keogh plan. An immediate-pay annuity begins paying regular payments as soon as one buys the contract – generally on a monthly basis.
Deferred This is the type most annuity investors choose. They appeal mostly to people in their forties or fifties looking to postpone paying taxes on their investment earnings for years to come, typically in retirement. One does not start receiving his income until he cashes in the contract, makes periodic withdrawals, or annuitizes. Deferred annuities could be compared with tax-sheltered CDs or mutual funds – with higher fees.
As long as the funds remain with the insurance company taxes are deferred. When funds are withdrawn from the annuity, they become taxable. For tax purposes, the IRS considers the first withdrawals to be interest since principle generally is not taxable. If the owner of an annuity is younger than 59 1/2 there may be an additional 10 percent federal tax on withdrawn interest. This tax feature enhances the annuity's value as a retirement vehicle.
A 55-year old man wants to put $100,000 in a safe place for his retirement. He purchases a fixed rate annuity. The insurance company guarantees 100% of his principle. At the current rate of 7.5% his retirement fund will be worth more than $200,000 when he reaches age 65. He pays no taxes on it until he begins to take the income. Even then, the company can design a tax-advantaged payment plan for him.
Single and Flexible Premium The Single Premium Deferred Annuity permits an individual to deposit a lump sum with the insurance company. It earns a fixed rate and is not currently taxable. The Flexible Premium Deferred Annuity permits the owner to make an initial payment and periodic additions. It earns a fixed rate and is not currently taxable.
Fixed-Rate The insurer pays a specific, fixed interest rate usually for a year, though some companies lock in rates for as long as 10 years. The earnings are tax-deferred if one goes with a deferred annuity. In recent years, fixed-rate annuities have paid 4% to 8% annually. Each year, the insurer announces the fixed return for the year ahead; the rate depends on the insurer’s current investment portfolio. Fixed-rate annuities are generally very conservative investments; they typically buy government and corporate bonds as well as residential mortgages. The fixed annuity pays a guaranteed rate of interest for a specified period of time. Rates can be guaranteed by the insurance company for one, three, five or more years, or they can be tied to indices such as Dow Jones Industrial Average. Most fixed annuities also have a minimum guaranteed rate of between three and four percent.
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Surrender Fees Fixed annuities are a fairly safe place for one’s money. The principle and the minimum rates are often guaranteed by the insurance company. Most have no initial sales charge, but they do have an early withdrawal penalty. It can be a pre-stated surrender fee or a market-value adjustment based on interest rate changes. If the purchaser of the annuity liquidates it in the first few years, a portion of the value may be forfeited to the insurance company. Surrender fees usually run from five to twelve years, depending on the company and the rate guarantees. Most fixed annuities permit withdrawals of earned interest or a percentage of the account value. Commonly, owners may withdraw up to 10 percent of the value at the end of the first year and in each year thereafter during the surrender fee period. Some annuities permit owners to accumulate these withdrawal rights. For example, an owner who takes nothing out in the first year may be permitted to withdraw 20% in the second year. When the surrender fee period is over, the owner can withdraw all of the funds without paying any penalties to the insurance company.
Bail-Out Rates Some annuities have bail-out rates. If the rate renews below a certain level, the owner can liquidate the annuity without paying any penalty charges. Often it seems there are as many varieties of fixed annuities as there are stars in sky, but there are basically two with a universe of creative variations.
Variable-Rate The return on this annuity fluctuates with the stock, bond, and money markets. A variable-rate annuity offers the potential for much higher returns than a fixed-rate contract, but at greater risk. Variable annuities are in essence mutual funds wrapped inside insurance contracts; again, the earnings are tax-deferred if one buys a deferred annuity. The insurance usually consists of a guarantee that one’s heirs will get back what he has invested.
The variable annuity permits an individual to invest in a variety of mutual fund portfolios and fixed accounts that are not subject to current taxation. Taxes are deferred until the money is withdrawn. Most variable annuities have fixed rate and/or money market portfolios, too.
Variable annuities look a lot like some retirement plans. There are many investment options: stock portfolios, bond portfolios, guaranteed rate accounts, and the taxes are deferred. Consider a stock portfolio growing at an average of 10% without being taxed over a 20-year period and one can see why these annuities are so popular.
$100,000 compounded at 10% for 20 years = $672,749.99
Some variable annuities have portfolios from only one mutual fund family, while others use money managers from diverse investment disciplines. Some variable annuities permit the owner to select an asset allocation system which invests based upon a predetermined plan and automatically re-balances at specified intervals. For example a plan that put 60% in growth and 40% in income funds would be re-balanced periodically to keep the mix at those proportions.
Variable Annuity Charges Here's an example of the charges one might find in a typical variable annuity:
• Administrative Fee : $35 annually
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• Mortality and Risk Expense : 1.40% annually of the value of the account
• Fund Management Fees : 0% to 1.50% depending on the type of portfolio
• Typical Surrender Fee Schedule:
o Year: 1 2 3 4 5 6 7 8 9 and thereafter
o Fee: 7% 7% 6% 5% 4% 3% 2% 1% 0%
Here's an example of how it can work: A 22 year old man inherits $100,000. He invests it in a variable annuity. He diversifies his funds among several stock portfolios ranging from very aggressive to blue chip. Over the next 28 years, he averages 10% in this investment after the annual management fees and mortality and risk charges of about 2%. His investment is now worth $1,442,099, and he still has paid no taxes on it. Now, at age 50, he wants to take a more conservative investment position. He moves the $1,442,099 from stocks to bonds. He still pays no taxes, because he has not taken the money out of the annuity. Over the next 15 years he averages at 6% return on his investment. At age 65 his variable annuity is worth $3,456,074. He retires, the bond market crashes, and his annuity is now worth $2,400,000. This makes him very ill, and he dies. His heirs receive a check for $3,456,074.
Death Benefit Today, most variable annuities have a death benefit that guarantees the greater of the original payment or the value at the time of death to the beneficiary (surviving heirs). This gives some investors an opportunity to be more growth oriented in their plan. Many variable annuities reset the death benefit periodically. They may do it annually or every few years. This means that the new value, if higher, is “locked in” as the guaranteed death benefit. If the new value is not higher, the previous death benefit remains “locked in.”
Variable Immediate Annuities Some companies also are beginning to offer variable immediate annuities. The annuitant may receive a guaranteed minimum payout, lower than the regular payout, but also has a chance of earning a higher payout. The investment choices are the same accounts that operate like mutual funds as those offered by the insurer's variable deferred annuity or variable life insurance policies. The risk, of course, is that payments will decrease if the markets go down. Another concern is that if the annuitant or the survivor of a joint-and-survivor annuity dies prematurely, the insurer keeps any remaining principal. It does not go to the annuitant's heirs. Should the annuitant die soon after making the investment, the amount lost could be substantial.
One can buy a ''term certain'' annuity, which guarantees payments for a certain number of years, say 10 or 20, even if he dies, his heirs would receive the remaining payments. Some companies offer a refund annuity, which pays out any remaining principal to heirs. Of course, both of these options mean one will receive a lower monthly payment.
Investors generally are locked into whatever annuity they buy. However, a few insurers allow annuitants to take out the remaining value, which could be valuable for someone terminally ill, for example.
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Sub-accounts The insurer offers an assortment of stock, bond, and money-market funds, called sub-accounts in annuity lingo, and give the investor the responsibility of choosing among them. The typical annuity offers about seven sub-accounts, with a variety of investment objectives. Some annuities, however, have more than 30 investment options. Within the stock category, he may be offered a selection of aggressive growth, blue-chip, and international funds. Within the bond funds, he can choose among corporate government, and high-yield portfolios.
Withdrawal With most investments, one does most of his research when he puts the money in. Annuity investors, however, may have to plan carefully when they are ready to cash out, too. Once surrender charges have expired, one can take his money out of the company that built up his account without penalty and take it to a competing insurer offering better terms. If it is invested in another annuity, he won’t have to pay the 10% early withdrawal tax penalty to the IRS. He will have to fill out the IRS’s 1035 Exchange form.
Annuitizing Before considering any withdrawal or payout from his annuity, he needs to understand annuitizing – turning over the accumulated value of his annuity to an insurer in return for fixed monthly income. Annuitizing has a distinct tax advantage; it lets one further postpone paying taxes on some of the earnings he has accrued. Each check he receives is considered only partly earnings; the rest is his original principal. He pays taxes only on the earnings and only as he receives them. If he wants to annuitize for the certainty of getting a specific amount of income each year, he’ll have to decide among three more choices:
Life Annuity By choosing a standard life annuity, the investor will guarantee himself a lifetime income. If he dies before the insurer thinks he will, he won’t get all the annuity income he was entitled to receive.
Joint-and-Survivor Annuity If one can afford to receive 5% or so less in his monthly checks, he can instruct the insurer to make sure his spouse or another dependent will keep getting paid after he dies – for as long as his beneficiary is alive. If the investor outlives the other person named in the annuity, he will keep getting checks until he dies. A Joint-and-Survivor annuity is sensible for most couples.
Life-With-Certain-Period Annuity This option assures one of a lifetime income while also guaranteeing payments for a set period of time, usually 10 years. If the annuitant dies within that time, his beneficiary collects the remaining payments.
Systematic Withdrawal Plan With this method, the investor tells the insurance company how much cash to send him from his account each month. Systematic withdrawal offers flexibility; at any time one can raise, lower, or stop the payments as well as annuitize. With this method one’s account could run out of money someday. What’s more, cash paid out in a systematic plan is usually fully taxable until one has drained all of his earnings from the annuity account.
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Tax Advantages One pays no taxes while his money is compounding. He can also pay a lower tax on random withdrawals because he controls the tax year in which the withdrawals are made, and only pays taxes on the interest withdrawn. Tax deferral gives him control over an important expense - his taxes. Any time he controls an expense, he can minimize it. The longer he can postpone this particular expense, the greater his gain when compared to the gain he would make with a fully taxable account.
Tax-Deferred Advantage To illustrate the increased earnings capacity of tax-deferred interest, compare it to fully-taxable earnings. $25,000 at 6.0% will earn $1,500 of interest in a year. A 28% tax bracket means that approximately $420 of those earnings will be lost in taxes, leaving only $1,080 to compound the next year. If these same earnings were tax-deferred, the full $1,500 would be available to earn even more interest. The longer one can postpone taxes, the greater the gain.
Safety One’s tax-deferred annuity is safe. A qualified legal reserve life insurance company is required to meet its contractual obligations to the investors. These reserves must, at all times, be equal to the withdrawal value of one’s annuity policy. In addition to reserves, state law also requires certain levels of capital and surplus to further increase policyholder protection. Legal reserve refers to the strict financial requirements that must be met by an insurance company to protect the money paid in by all policyholders. Theses reserves must all times, equal to the withdrawal value (principal plus interest less early withdrawal fees, if any) of every annuity policy. State insurance laws also require that a life insurance company must maintain certain minimum levels of capital and surplus, which provide additional policyholder protection.
No More 1099s There is no withholding tax while the annuity is compounding; it is completely tax-deferred. If one requests a distribution (random withdrawals or annuity income), taxes will be withheld - unless he elects differently. His election not to withhold can be made at the time he makes his request. Because the interest is tax-deferred, it is not necessary to issue a Form 1099 while the money is compounding. Only when the interest is distributed (withdrawal or annuity income) will a Form 1099 be sent, reflecting the amount of interest actually received.
Penalty Tax An IRS penalty tax, currently 10%, may be payable on any withdrawal of interest or qualified premium made prior to age 59 1/2.
Probate If a premature death should occur, the accumulating funds within one’s annuity may be transferred to his named beneficiaries, avoiding the expense, delay, frustration and publicity of the probate process. Like most assets, the annuity is part of his taxable estate. His heirs can choose to receive a lump sum payment, or a guaranteed monthly income.
Compared With Other Investments The selling points of a variable annuity are that the underlying investments grow tax-deferred, as in an IRA, and that when one retires, the annuity will pay him an income, based on how well the
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underlying investment performed, for as long as he lives. Annuities are sold by insurance companies, and use an insurance policy to provide the tax deferral. Remember, tax deferral is not tax-free. It means that taxes are delayed.
Unlike an IRA, the money one puts into an annuity is not deductible from his taxes. And also unlike an IRA, he may put as much money into an annuity as he wishes.
The growth of an annuity is fully taxable as income, both to the investor and his heirs. The growth of an index fund is taxable as capital gains to him, which is good because capital gains taxes are always lower than ordinary income, and subject to zero income tax to one’s heirs. This last point is because upon inheritance the asset gets a "stepped up basis." In plain English, the IRS treats the index fund as though one’s heirs just bought it at the value it had when the investor died. This is a major tax advantage if one cares about leaving his wealth for his heirs. By contrast, the IRS treats the annuity as though one heir just earned it; they must now pay income tax on it.
If one removes some money from the index fund, the cost basis may be the cost of his most recent purchase. By contrast, any money one removes from an annuity is taxed at 100% of its value until he brings the annuity's value down to the size of what he put in. The law is more favorable for annuities purchased before 1982.
Negative Features of Annuities Some financial advisors feel that annuities are a poor way to invest one’s money. Here are some of their arguments. Annuities usually have a sales load, usually have very high expenses, and always have a charge for mortality insurance. The insurance is virtually worthless because it only pays if one’s investment goes down and he dies before he "annuitizes". Simple term insurance is cheaper and better if one needs life insurance.
Annuities invest in funds that are difficult to analyze, and for which independent reports are not always available. Annuity contracts are very difficult for the average investor to read and understand. No one should sign a contract they don't understand.
Annuities promise a guaranteed income for life. If one chooses to annuitize his contract – take the guaranteed income for life, two things happen. One is that he sacrifices his principal. When he dies he leaves zero to his heirs. If he wants to take cash out for any reason, he can't. It isn't his anymore. He has made the insurance company rich. In exchange for giving all his money to the insurance company, they promise to pay him a certain amount, either fixed or tied to investment performance for as long as he lives. The problem is that the amount they pay the investor is small. The very small pay off from annuitizing is the reason that almost no one actually does it.
If one is considering an annuity, he should ask the insurance company what percentages of customers ever annuitize. Ask what the pay off is if one does annuitize and he will see why. The potential investor should compare their pay off to keeping his principal and putting it into a ladder of U.S. Treasuries, or even tax-free monies. Better yet, compare the payoff to a mortgage for the duration of his expected lifespan. If one expects to live to 85, compare the payoff at age 70 to a 15-year mortgage with himself as the lender.
Now let's consider a variable payout, determined by the performance of one’s chosen investments. The problem here is the Assumed Interest Rate (AIR), typically three or four percent. The insurance
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company skims off the first three to four percent of the growth of one’s investments. They call that the AIR. One’s monthly distribution only grows to the extent that his investment grows more than the AIR. So if his investment doesn't grow, his monthly payment shrinks (by the AIR). If his investment grows by the AIR, his monthly payment stays the same. When the market has a down year, one’s monthly payment shrinks by the market loss plus the AIR.
Special Features of Annuities
• Tax-deferred compounding
• All earnings are tax-deferred
• Over time, this added compounding can mean a larger retirement fund, even after taxes when one begins to take payments
• Unlimited tax-advantaged investment amounts
• No limit to the amount one can invest in an annuity
• Can defer a greater amount of investment earnings from current taxes
• Guaranteed return to one’s beneficiary
• If one dies, his beneficiary is guaranteed to receive the greater of the amount he invested or the annuity's cash value, less withdrawals
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