Qualified Versus Nonqualified · that earnings grow income tax deferred in the same manner as any...

Introduction

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Introduction

As we begin this course on Annuity Riders and Suitability of Transactions, it may be beneficial toreview some of the basics about annuities. Fundamentally, annuities are insurance company productsthat are designed to systematically liquidate a sum of money, or an estate, through a series ofperiodic payments that the annuitant cannot outlive. This happens when the annuity contract hasbeen annuitized. There is no other product in the financial services arena that is designed, or has theability, to make this promise.

Today, folks are being offered opportunities to purchase annuities by their life insurance agents andfinancial advisers, their banks and credit unions, even some of their mutual fund companies androadside assistance motor clubs. If it weren’t for the fact that annuity sales are overseen by stateinsurance regulators, we would probably find annuities being sold on the shelves of discountsuperstores. No matter who it is that’s offering the product, or where or how they are beingmarketed, annuities are only obtained from life insurance companies.

Annuities are not the same as life insurance, but they are an insurance product. In fact, annuitiescould be described as the exact opposite of life insurance—like heads or tails of a coin. Lifeinsurance is understood as a product that creates an immediate estate when a person dies, andannuities are designed, as we’ve said, to liquidate an estate during a person’s lifetime.

Annuities are broadly classified in several ways. Let’s take a quick look at these classifications.

Qualified Versus Nonqualified

Evaluating Annuity Riders and Annuity Suitability of Transactions - 32002574

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Qualified Versus Nonqualified

First, annuities are either qualified or nonqualified. Qualified annuities are those that holdretirement plan assets—money contributed to a person’s pension plan, 401(k), 403(b), or IRA as anexample—and are all funded with pretax dollars from a person’s earned income. In other words, thecontribution is deductible prior to computing taxes. Nonqualified annuities are funded with after-taxdollars, which could come from earned income, but could also come from unearned sources such aslife insurance proceeds, inherited money, or as the result of a settlement from an injury or other legalclaim. The proceeds from the sale of real estate, stocks, bonds, or mutual funds, even lottery orgambling winnings, could be used to purchase a nonqualified annuity.

Whether qualified or nonqualified, the interest earned or the stock market gains (or losses) enjoycertain privileges under the Internal Revenue Code (IRC). Perhaps the most important of these isthat earnings grow income tax deferred in the same manner as any retirement plan. Also,distributions from annuities are governed under many of the same restrictions that apply toretirement accounts.

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Qualified Versus Nonqualified (cont.)

When distributions are taken from an annuity, there will be an income tax liability on any portion ofthe distribution that represents a gain over the cost basis. Qualified annuities will be taxed on 100%of the distributed funds because no income tax was paid on the contributions. In other words, aqualified annuity has no cost basis. This is exactly the same as any other qualified retirementaccount. Distributions of principal from nonqualified annuities, however, are not taxable, but theIRC requires that unless the distributions are being made in the form of “a series of substantiallyequal payments based on the life expectancy” of the annuitant, all taxable gains will be distributedbefore any non-taxable principal is received: last in, first out, or LIFO. This assures the governmentthat it will receive its share of income tax first.

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Please reference the online course to view this activity.

Immediate Versus Deferred

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Immediate Versus Deferred

Distributions from annuities are either going to be immediate or deferred. An immediate annuitymakes its first payment sometime within the first 12 months after it is funded, commonly within onemodal period (e.g., month, quarter, semester, annual). A deferred annuity is one that is not intendedto be annuitized for many years—at least eight to ten years or more—into the future. A nonqualifiedannuity is never required to be annuitized. Even a qualified annuity may not have to be annuitizedduring the lifetime of the owner/annuitant, as long as any required withdrawals are taken.

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Fixed Versus Indexed Annuities

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Fixed Versus Indexed Annuities

Originally, all annuities were fixed annuities. Consumers today have a wide variety of fixedannuities from which to choose. These contracts promise a minimum fixed rate of interest set by theinsurance company when the contract is issued. The interest rate can be changed, up or down fromtime to time, but those changes are at the sole discretion of the insurance company. The insurancecompany is never required to offer a greater rate of return than the minimum guarantee, and it


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cannot credit less. Some insurance companies offer an initial interest bonus in the first year or aspecial interest bonus after 10 years. When annuitized, a fixed annuity provides a fixed payment,which exposes the annuitant to purchasing power risk, the primary hazard of inflation.

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Fixed Versus Indexed Annuities (cont.)

Fixed indexed annuities (FIA) offer the attraction of a variable interest rate based on theperformance of a stock market index (such as the S&P 500 Index) or another unmanaged index(such as the LIBOR bank rate index). However, there is no direct investment in the index or anystock market, and the index rate is not under the control of the insurance company (both fixedannuities and FIAs are general account products of the insurance company). FIAs offer contractowners the opportunity for greater tax-deferred appreciation compared to fixed annuities.

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With the FIA, there is excellent upside potential in a rising market environment, but it is notunlimited due to the rate cap and participation rate limitations in the contract. Because it is a type offixed annuity, the FIA also guarantees a minimum interest rate (0% is a guarantee). It may also besaid that indexed annuities offer downside protection against the loss of principal or accumulatedvalue because of the minimum interest rate guarantee. Depending on contract design, whenannuitized, many FIAs offer the potential for increasing periodic payments based on theperformance of the benchmark index. Given the lackluster performance of the US stock marketsover the past 10 years, there is little wonder why FIAs have become very popular during this sametime period. We will cover FIAs in more detail a bit later.

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One final point needs to be clear. Because neither the fixed nor FIA annuities are securities, there is


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no requirement for an agent to also be registered as a representative of a broker/dealer to offer them.The only license requirement is that of insurance agent.

Variable Annuities

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Variable Annuities

Variable annuities (VAs) offer sophisticated individuals with prior investment experience theopportunity for stock market-based rates of return with unlimited upside potential and the advantageof tax-deferred earnings. However, because a VA represents direct participation in the stock markets,there is no guarantee of principal and no guaranteed interest rate. In fact, a VA may lose value;although highly unlikely, it could lose all of its value. Unlike fixed or indexed annuities, the contractvalue is held in the insurer’s separate account, earmarked for the owner and protected from theclaims of creditors. The separate account comprises a variety of subaccounts that range from veryconservative to highly aggressive, and contract owners should be encouraged to create a diversifiedportfolio to minimize the risk of loss while attempting to obtain the best rate of return.

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Variable Annuities (cont.)

VAs are complex, and the products are not suitable for all persons. During the accumulation period,owners must manage the annuity for the best possible return consistent with their risk tolerance.Portfolios should be rebalanced periodically, investment choices reevaluated from time to time, andchanged as needed. When the owner’s management activity results in positive returns, the VA is saidto be providing a hedge against inflation. Additionally, after annuitization, separate accountperformance directly affects the periodic payment. Positive returns in the separate account mayresult in a larger payment, but negative (or insufficient positive) returns will cause the periodicpayment to decrease which can result in shrinking payments that could take many months ofconsistent and higher-than-expected returns to overcome.

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Combination Annuities

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Combination Annuities

Combination annuities are a blend of fixed and variable annuity components in a single contract.The variable component needs to be properly managed. When the contract is annuitized, the fixedcomponent establishes a base from which the monthly payment will be established, and the variablecomponent, through proper management, continues to provide its potential hedge against inflation,which is the primary appeal/selling point of VAs. Both VAs and combination annuities offer theadvantage of tax-free transfers of funds from one subaccount to another.

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Comparing Annuities to Life Insurance

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Comparing Annuities to Life Insurance


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Annuities are not life insurance, but they are an insurance product. Whether they are fixed, indexed,or variable, the insurance producer (and registered representative when VAs are involved) mustremember that, as insurance products, annuities should never be marketed as investments. Thevarious states’ insurance codes, as well as the rules of both the Securities and Exchange Commission(SEC) and the Financial Industry Regulatory Authority (FINRA), make it clear that variableinsurance products are insurance products first, and they have an investment component that otherproducts do not.

Life insurance is a product designed to leave money to persons the insured leaves behind when theinsured dies. That money may be left for the direct benefit of the beneficiaries or it may be intendedto pay taxes and other expenses of the decedent in order to preserve his accumulated assets orestate. If a life insurance contract has cash value, any growth or gains are tax deferred, and theowner of the policy has access to the cash value through policy loans (or withdrawals in somecontracts) prior to the death of the insured. When the death benefit is paid, it is generally receivedby the beneficiary tax free. The value of the life insurance proceeds is includable in the owner’sestate for estate tax purposes.

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Comparing Annuities to Life Insurance (cont.)

Annuities are products designed to benefit living annuitants by providing income throughout theirlifetime. That income will be fully or partially taxable. An additional benefit, owing to its lifeinsurance roots, is that the annuity value may be passed to a beneficiary if the owner dies before thecontract is annuitized. However, unlike life insurance, that death benefit is not always tax free (infact, it is rarely entirely tax free). Any amount the beneficiary receives in excess of the cost basiswill be taxable to the beneficiary as ordinary income. Proceeds from a qualified annuity, because ithas no cost basis, will be fully taxable to the beneficiary.

Perhaps the best way to describe the difference between life insurance and annuities is to understandthe difference in the owner’s objective; life insurance is designed to protect against the financialturmoil when a person dies too soon. Annuities are designed to protect against the financial turmoilof living too long. Together, they address two basic aspects of life—not living long enough to reachfinancial independence and living so long as to deplete all the money one has saved.

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Comparing Annuities to Retirement Plans

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Comparing Annuities to Retirement Plans

It is unlawful to market life insurance contracts as either a retirement plan or a retirement product.Insurance companies have paid multimillion dollar fines for allowing or encouraging such marketingactivities by their agents, and agents have been sanctioned. Annuities, however, are commonlyconsidered and may be marketed as retirement products, not plans. They are typically used toaccumulate or hold additional funds specifically for one’s later years. Indeed, annuities areincreasingly being used to convert accumulated investment assets or other liquidated assets such ashomes, personal property, or businesses into a source of lifetime income that the assets themselveswould not otherwise provide. Unless an annuity is specifically being used to hold retirement planassets, it is still not permissible to call it a retirement plan.

Many insurance companies decline new applications for nonqualified annuities when the owner isnot (1) fully funding any qualified retirement plans available to her, (2) using the annuity for astructured settlement from a personal injury lawsuit, or (3) using the annuity as the holdingmechanism for a cash windfall, such as an inheritance.

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Comparing Annuities to Retirement Plans (cont.)

Unlike qualified retirement plans, with a nonqualified annuity (1) there is no limit to the amount ofmoney one may contribute (other than amounts exceeding the maximum the insurance company willaccept without prior approval), (2) there are no income restrictions that limit one’s ability tocontribute, (3) there are no age limits on contributions (although most insurance companies will notaccept new applications from persons over age 84 who are not already clients of the company), (4)contributions may come from any source, including passive income or income in respect of adecedent (e.g., life insurance, inheritance, or retirement plan distributions), and (5) there is generallyno requirement to ever annuitize. For those persons who are fully funding all qualified plansavailable to them, annuities usually represent the best, and perhaps only, option for obtainingadditional tax-deferred growth on their savings.


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From a taxation perspective, annuities and most retirement plans share a number of commoncharacteristics. Once money is contributed to the annuity, it grows income tax deferred, like aretirement plan. If it is a VA, whether qualified or nonqualified, transfers between subaccounts tomaintain or change the portfolio’s asset allocation are not considered a sale and are not subject tocapital gains tax. Distributions from both annuities and retirement plans are taxed as ordinaryincome. Once money has been paid into the annuity, there is virtually no way to access that moneywithout an income tax liability. Like retirement plans, certain withdrawals prior to age 59½ aresubject to a 10% penalty tax (the only escapes in annuities are the death or disability of theowner). All withdrawals must come from gains (earnings) first (LIFO), making those withdrawalstaxable.

Generally, the only way to obtain money from an annuity without an income tax liability is when anonqualified VA has lost value and is now worth less than its cost basis. Withdrawals in that situationwould not be taxable, and it would generally not create a deductible capital loss. And as has beensaid, the beneficiary of an annuity will incur a tax liability on any gains over the annuitant’s costbasis the beneficiary receives. Special distribution and tax rules apply when the beneficiary is thespouse of the decedent.

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If the annuity is qualified, the owner/annuitant will be subject to Required Minimum Distributions(RMDs). Beginning at age 70½ (technically, by April 1 of the year following the year one turns age70½), the owner may need to withdraw funds from the annuity to satisfy his RMD amount for theyear (the value of all qualified plans are aggregated to determine the RMD; however, withdrawalsmay come from any one or more of the plans). It does not matter whether a person needs the moneyor not; failure to take the RMD in whole or in part results in a 50% penalty tax on the undistributedamount. However, when a qualified annuity has been annuitized, the RMD rules do not applybecause the payments represent a series of substantially equal amounts based on the annuitant’s lifeexpectancy and the IRS distribution tables, and they are already generating income tax liabilities.


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The singular exception to all of this is an annuity that holds Roth retirement account assets (Roth401(k), Roth 403(b), or Roth IRA). Because Roth accounts are not subject to the age 70½ rule,distributions are not required, and the annuity is never required to be annuitized. When theowner/annuitant dies, a beneficiary will receive the annuity tax free, along with the ability towithdraw the proceeds both penalty and income tax free, regardless of the annuitant’s age. As thebeneficiary, a spouse may continue the Roth IRA as his or her own and may contribute earnedincome every year with no requirement to ever take any distributions. If the beneficiary is not thespouse, then certain minimum withdrawals will be required based on life expectancy, but this favorsyounger beneficiaries, and the account may continue to grow in value. Without ever annuitizing, itmay be passed on repeatedly to other beneficiaries in future generations until the account isdepleted, providing tax-free income for multiple lives. Many life insurance producers are unaware ofthis, and it is a seldom exploited, yet perfectly lawful, use of qualified annuities.

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Introduction

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Introduction

Before going further, it is important to understand and remember that although annuities may offermany features that are similar to true investments, such as mutual funds or exchange-traded funds,they are first, and foremost, insurance contracts. Even variable annuities cannot be marketedexclusively as an investment; while they may have an investment component, they are not


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investments alone.

Comparison of Fixed Annuities to CD’s and Other Fixed Savings Vehicles

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Comparison of Fixed Annuities to CDs and Other Fixed Savings Vehicles

Many conservative savers choose to hold a significant portion of their savings in fixed incomevehicles, such as certificates of deposit (CDs) and corporate and municipal bonds. With theexception of municipal bonds, these savers are exposed to annual taxation on their interest income.Over time, taxes erode the value of their savings, as does the negative effect of inflation on theirpurchasing power because the returns are fixed. By virtue of their tax-deferred growth, annuitiesoffer an attractive alternative to these taxable products, even when the returns are fixed.

One of the factors that may influence a person’s choice of bank CDs is the FDIC insuranceprotection, currently a maximum of $250,000 per person, per institution. However, in exchange forthis protection, accountholders currently receive very poor rates of return. In the current economicenvironment, at the end of 2011, the average rate for a five-year CD in the United States was only1.61%!1 By comparison, the non-seasonally adjusted all items inflation rate was 3.4%.2 A person inthe 25% marginal tax bracket would have an after-tax return of just 1.21% and would lose more than2% in purchasing power as a result of locking his money in a safe CD.

The tax-deferred growth of annuities allows the accumulated value to surpass that of the CD, and atthe end of December 2011, a number of fixed, multiyear guaranteed fixed annuities (MYGA) wereoffering a five-year rate of 3.6%, 6% more than the current inflation rate and triple the after-tax rateof the average CD. 3

1 Accessed at http://www.bankrate.com on December 31, 2011.2 Accessed at http://www.bls.gov/cpi/ on December 31, 2011.3Accessed at http://www.annuityratewatch.com/rates/myga_yield_curve.cfm on December 31, 2011.

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Comparison of Fixed Annuities to CDs and Other Fixed Savings Vehicles (cont.)


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While it is true that there is no FDIC coverage for annuities, each state does have a Life InsuranceGuarantee Association that offers limited protection for annuity benefits and cash values. However,each state’s insurance laws also prohibit discussing the protection afforded by the GuaranteeAssociation prior to delivering the contract to the client. You can find information about your state’sGuarantee Association and its statutory coverage through the National Organization of Life &Health Insurance Guaranty Association’s Website. (http://www.nolhga.com/policyholderinfo/main.cfm/location/ga)

Fixed annuities, when suitable for the prospect or client and presented properly, offer the mostconservative savers an attractive and reasonably secure alternative to today’s very low-yielding bankaccount options. For those clients whose attitude toward risk is a bit less conservative, they may findthe features and benefits of a fixed indexed annuity a more suitable alternative to traditional or evenMulti Year Guarantee Annuity (MYGA) fixed annuities.

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Comparison of FIAs to Index Mutual Funds/ETFs

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Comparison of FIAs to Index Mutual Funds/ETFs

An FIA is an attractive variation on fixed annuities that may be of interest to all but the mostconservative prospects. Offering a minimum interest rate guarantee, perhaps equal to or greater thanaverage CD rates, FIAs offer the advantage of growth based on the performance of a benchmarkindex, such as the S&P 500. Insurance producers sometimes market FIAs (and equity-indexed lifeinsurance) inappropriately by claiming they provide all the upside of the market with none of thedownside. Statements such as this are inaccurate and misleading and should never be used in thesales process.

FIAs closely resemble index mutual funds and exchange-traded index funds (ETFs) but with onecritical difference: policyholders do not directly invest in the stock market, as is the case with ETFs,through their indexed annuities. Like fixed annuities, FIAs are general account insurance products,and only the insurance company bears the interest rate risk of its promises to policyowners. FIAs


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typically change the interest crediting on a point-to-point basis, and the policyowner may select frommonthly, annual, or other frequencies that may be available, or the insurer may use a more complexmarket value adjusted (MVA) approach that does not actually value the contract until a withdrawalis made or the contract is annuitized. The insurance company must determine how it will cover itsliability to policyowners, and it may choose to invest its policy reserves in ETFs or other securities.

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Comparison of FIAs to Index Mutual Funds/ETFs (cont.)

To the policyowner, if the benchmark index has risen since the last measurement, the interestcrediting rate will increase during the next measurement period. The upside in an FIA, however, isnot unlimited. It may be subject to a participation rate of less than 100% and will always include arate cap. The participation rate is the percentage of the index gain that will be credited to thecontract. If the index gained 10% in one year, an 80% participation rate would set the next year’sinterest crediting rate at 8%. Rate caps limit the insurance company’s exposure to a rapidlyadvancing market. If the index gained 20%, the 80% participation rate would entitle the contract tobe credited with 16% interest, but a 12% rate cap limits the crediting rate to a maximum of 12%. Notthat this is anything to be upset about, but it’s not the same as getting all the upside of the market, aspeople would in their index mutual fund or ETF—there are no upside limitations in true investmentproducts. But investment products are also subject to negative returns

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Comparison of FIAs to Index Mutual Funds/ETFs (cont.)

The stock markets are not a one-way vertical ride. Markets do go into periods of decline, and whenthe index declines, FIA interest crediting rates will also, but they’ll never fall below the minimumguarantee. There is downside protection with a 0% interest guarantee—the cash accumulation willnever decline because market returns are negative (any usual policy expenses will continue to bededucted), but 0% offers no growth at all. Many FIAs do offer a 1% or 2% minimum guarantee, butthe tradeoff may come in the form of reduced participation rates or rate caps. In comparison, mutualfunds and ETFs cannot offer their investors any protection from a declining market, and investorscan lose value as a result.

A true advantage of FIAs to either mutual funds or ETFs is the protection of the minimum interestguarantee. In the 2000–2010 period, annual market declines of 40% or more in some of the majorstock indexes happened in some years. Mutual fund and ETF investors might require many years ofpositive growth to overcome one bad year; losing 40% in one year and earning 100% the next does


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not mean you are 60% ahead of where you were two years ago. The FIA owner would not sufferthat same fate; they might not have any growth, but they will not suffer any loss. The disadvantageto the FIA owner is the combination of the participation rate and rate caps that can limit the growthpotential. Seeking the best of both for your client will minimize the difference between the actualannuity growth and the true market performance.

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Comparison of Variable Annuities to Stocks, Bonds, Mutual Funds/ETFs

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Comparison of Variable Annuities to Stocks, Bonds, Mutual Funds/ETFs

For the more sophisticated client—in particular, one who has prior experience with investing andmanaging her portfolio—variable annuities offer the advantage over stocks, bonds, mutual funds,and ETFs of income tax deferral that cannot be obtained outside a retirement account. For the moreaffluent client, who has maximized all of his qualified retirement plan contributions and has noadditional need for life insurance, VAs offer the one remaining choice for saving money on atax-deferred basis without using any of that money to pay for the cost of life insurance that wouldhappen in a variable life insurance or variable universal life insurance product.

In any variable insurance product (annuities or life insurance), the product’s cash accumulation is inthe insurance company’s separate account. It is not available to pay company operating expenses,nor is it available to creditors of the insurance company or those of the policyowner. The separateaccount is registered with the SEC and invests that money through a variety of subaccounts thatclosely resemble mutual funds. The subaccounts are also registered with the SEC and regulated asmanagement investment companies.

Policyowners are responsible for determining their risk tolerance and apportioning their cashaccumulation among the available options to create a well-allocated portfolio. They bear all theinvestment risk in the performance of their chosen subaccounts. They could enjoy phenomenal gainsand have to endure spectacular declines, sometimes in the same day, week, month, or year! It’s easyto talk about the positive aspects of a rising stock market and what that means in terms of


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tax-deferred growth.

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Comparison of Variable Annuities to Stocks, Bonds, Mutual Funds/ETFs (cont.)

However, there are also no guarantees in a basic VA contract. Although highly unlikely, thepolicyowner could potentially lose her entire account value. That is a disadvantage that cannot beoverlooked, and it cannot be left unsaid when marketing a VA. The good news is this is no differentthan stocks, bonds, mutual funds, or an ETF. However, VAs do have some layers of fees andexpenses that mutual funds do not, and this, too, is a disadvantage that must be discussed. Inaddition, VAs are not covered by state life insurance guarantee associations, so don’t even thinkabout failing to mention that when you deliver the policy!

For your clients who understand the dynamics of the stock and bond markets, are aware of the worldeconomic situation, and have the time and temperament to manage their portfolio, a VA may be justwhat they are looking for when it comes to minimizing their current taxable income. No otherproduct can do what a VA can do for them.

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Introduction

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Introduction


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Just as with life insurance, a basic contract only covers the most common needs of mostpolicyowners. Each owner’s situation is unique, and there simply are no one-size-fits-all insurancecontracts. Insurance companies recognize this, and they offer riders and endorsements that allow thecontract to be customized to a limited extent and more closely meet the client’s needs. The goodnews is this: if a client wants something that the insurance company is not currently offering, theclient is free to propose his need to the insurance company. If the insurance company sees a way toprovide the benefit and make a profit, it can create a new rider or endorsement to meet that need.Each of the riders we explore next have been developed on the basis of actual client needs or whatthe insurance company perceives client needs might include.

In reviewing some of the most common riders available in the insurance marketplace today,understand that not all riders are offered by all insurance companies, and slight variations occur fromone company to another in the title or language of the riders. The cost of each rider, if any, alsovaries from one company to another. It is your responsibility as an insurance producer and registeredrepresentative to fully familiarize yourself with the products and riders you have available to marketto your clients and to market those products accurately.

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Introduction (cont.)

The National Association of Insurance Commissioners’s (NAIC) new Suitability of AnnuityTransactions Model Regulation is now in effect in all states, and it demands that insurancecompanies document the fact that employees have been trained in their specific annuity product(s)they market before they may begin marketing them. Many states place additional emphasis ondealings with seniors because they are the main target of annuity sales and because they have only alimited opportunity, if any, to recover from the financial effects of a poorly made decision. A numberof states require that seniors be given a scope of appointment notice at least 24 hours in advance ofany insurance sales meeting that will take place in their home.

Finally, all annuity benefits, including those described in any rider, are solely dependent on theclaims-paying ability of the insurance company that issues the contract.

Various Riders Commonly Available for Annuities

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Cost-of-Living Adjustment (COLA)


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Annuity COLA riders are similar to those seen in life insurance and disability income policies.Policyowners may designate a specific amount of simple or compound increase in their periodicpayment that applies after the contract has been annuitized. Selectable amounts range from 2% to6% or more but will reduce the amount of the initial payment based on life expectancy compared toa contract without the rider. This rider may only be available with a single premium immediateannuity.

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Cash (or Installment) Refund

If not offered as a standard distribution option in the contract, this rider allows the beneficiary toselect a lump sum or periodic payment of remaining annuity value if the annuitant dies prior tocollecting the full cost basis/purchase price in the contract. Installment payments will include interestuntil the principal has been fully returned, at which time payments end.

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Impaired Risk (Medically Underwritten)

Often overlooked by agents, an impaired risk rider allows an annuitant to be medically underwrittento determine life expectancy in comparison to annuity mortality tables. This only applies to singlepremium immediate annuities. If life expectancy is confirmed as being shorter than that of a standardrisk, annuitants may obtain a larger payment for the amount of their purchase premium or the samepayment as a standard risk would receive, but with a smaller purchase premium.

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Commuted Payout

This rider permits a lifetime income benefit to be paid to the annuitant, but it also offers limitedopportunities to withdraw additional money from the contract. The opportunity to withdraw theselump sums may be limited to a single amount in the first year or two of the contract, to a maximumamount per withdrawal and maximum withdrawal amount, or to a percentage of the purchase


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premium.

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Guaranteed Minimum Accumulation Benefit (GMAB)

This rider is seen only in deferred variable annuities and establishes a benchmark value for thecontract if held a certain number of years (commonly five or ten). A GMAB typically restores thevalue of the annuity to the original purchase premium (less any withdrawals) if the actual value islower due to market performance. Some variations of this rider guarantee to double the purchasepremium (less any withdrawals) at the end of 10 years if the actual cash accumulation is less thanthat amount. If the standard contract does not include a cash accumulation step-up or lock-inprovision, this rider may add that benefit to the contract beyond the valuation guarantee date.

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Guaranteed Minimum Withdrawal Benefit (GMWB)

This rider is also only seen in deferred variable annuities. It permits the owner to withdraw 100% (ormore) of the original purchase premium over the life of the contract. Withdrawals under this riderare usually limited to a specific percentage of the purchase premium, such as 5%, 8%, 10%, or moreper year. It guarantees that the owner will be able to obtain the full original value of the contracteven if the separate account performance causes the cash accumulation to decline below thepurchase premium.

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Guaranteed Minimum Income Benefit (GMIB)

Seen in both fixed indexed annuities and variable annuities, this rider guarantees an annuity incomebased on a hypothetical interest rate (conservative, such as 5% to 7%) over a specific period of timeor on a fixed percentage of the initial purchase premium (such as 5% or 10%), neither of whichaffects, or is affected by, the actual contract cash accumulation. The annuity income, however, isalways based on the greater of the actual accumulation value or the rider benefit as calculated. Some


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FIAs are offering annual preannuitization rollups of 10% to 14% of the purchase premium in years1–8 or 1–10, which can double (or more) the purchase premium’s value for the purpose ofestablishing a higher minimum income level at annuitization if the actual cash value is lower.

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Guaranteed Lifetime Withdrawal Benefit (GLWB)

One of the more commonly offered riders in fixed indexed and variable annuities, this rider allowsthe annuitant to receive a lifetime income without annuitizing the contract. In addition to the lifetimebenefit, the rider usually includes a provision that allows the owner to make unscheduledwithdrawals up to the cash value of the contract (both the income payments and withdrawals reducethe available cash accumulation). Income payments will continue beyond the depletion of the cashaccumulation for the lifetime of the annuitant. GLWB riders may include a refund of remaining cashaccumulation if the annuitant dies before receiving the full value of the contract.

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Long-Term Care

Increasingly being seen in both deferred annuities and life insurance, this rider permits the use of upto 100% of a non-annuitized annuity’s cash accumulation value without surrender or excesswithdrawal charges when the annuitant satisfies the conditions for being classified as disabled undera tax-qualified LTC policy (disabled in two or more of the six activities of daily living or a diagnosisof Alzheimer’s disease or other cognitive impairment). Benefit usage will be limited to a certainnumber of dollars per day. (Note: Since 2010, the IRC also permits the use of the §1035 Exchangeprivilege to exchange annuities or life insurance for a standalone LTC policy. The annuity cost basisand actual cash value transfers to a LTC policy on a tax-deferred basis, and the benefits are nottaxable when used to pay for qualified LTC expenses. The LTC policy must provide for a cashaccumulation/nonforfeiture value in the contract. If the LTC contract is later surrendered ordistributed following the death of the insured, any distributed gain in excess of cost basis is taxableto the beneficiary as ordinary income. There are only a few such LTC policies currently available for§1035 Exchanges.)

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Disability Income/Unemployment

Available with most deferred annuities, this rider permits withdrawals without surrender charges ifthe annuitant is disabled. There is usually an elimination period of six months to one year before theannuity cash accumulation may be accessed under the terms of the rider. Some riders extend thebenefit to those who are unemployed for at least six months (and receiving unemployment benefits).

Page ID: 526338

Terminal (or Critical) Illness

This rider is now commonly included at no cost with most deferred annuities, and it permitswithdrawal of up to 100% of the accumulated value without a surrender charge when the owner isdiagnosed with a terminal illness that is expected to result in death within 12 months. Actual hospitaladmission or home confinement is not required.

Page ID: 526339

Activity


Recommending Riders

Page ID: 526341

Recommending Riders

Before recommending any annuity or rider, it is now incumbent on all producers to perform a properanalysis of the consumer’s situation and needs. This is not a cursory event or process; it should notbe a casual discussion between the producer and the customer merely to see how much money is


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available for the transaction.

The availability of many annuity riders is usually limited to the original application process andcertainly not after a contract has been annuitized. A particular rider may be highly suitable for acustomer’s situation and an important reason for a customer’s decision to exchange an existingannuity for a new contract. Producers, however, must remain aware of the risk of loss to thecustomer through surrender charges and not recommend a contract exchange merely for the sake ofobtaining a rider. Simply recommending a new annuity with its rider may be a better option. Ifchoosing a deferred annuity contract, funds from an existing annuity may be added later when theyare no longer subject to a surrender charge.

Page ID: 534943

Activity


The New NAIC Model Regulation

Page ID: 526344

The New NAIC Model Regulation

For several years, the National Association of Insurance Commissioners (NAIC) has been workingon a set of standard annuity transaction guidelines all the states could agree to enforce. That workwas completed in 2010 and subsequently adopted in all states, with varying degrees of minorvariations, by the end of 2011. On January 1, 2012, the new regulations took effect in all states. Thefollowing discussion is based on the Model Regulation. Your state’s adopted version may beidentical, or it may be worded slightly different. If you are licensed in more than one state, it is yourresponsibility to know and comply with the laws of every state in which you do business.

In advance of state adoption of the NAIC Model Regulation, many insurance companies had alreadybegun to modify their suitability standards in compliance with what would eventually be adopted.There was a broad general consensus in the industry that the guidelines were necessary, andinsurance companies were given ample opportunity to provide input to the NAIC.


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Page ID: 526345

The New NAIC Model Regulation (cont.)

The stated purpose of the regulation is “to require insurers to establish a system to superviserecommendations and to set forth standards and procedures for recommendations to consumers thatresult in transactions involving annuity products so that the insurance needs and financial objectivesof consumers at the time of the transaction are appropriately addressed” and it applies to “anyrecommendation to purchase, exchange, or replace an annuity made to a consumer by an insuranceproducer, or an insurer where no producer is involved, that results in the purchase, exchange, orreplacement recommended.”

The Model Regulation does not apply to ERISA preempted employer-sponsored pension or welfarebenefit plans; to IRC §§401(a), 401(k), 403(b), 408(k), or 408(p) employer-sponsored retirementplans; to IRC §414 or §457 church and government-sponsored plans; nonqualified deferredcompensation plans; structured settlements as the result of personal injury litigation; or to prepaidfuneral contracts.

When it comes to a producer’s involvement, recommendation means advice provided by aninsurance producer to an individual consumer that results in a purchase, exchange, or replacement ofan annuity in accordance with that advice. The regulation uses the same definition of replacementthat applies to life insurance transactions.

Page ID: 526346


The Model Regulation also sets forth 12 items the NAIC consider key determiners of the suitabilityof a recommendation to purchase an annuity. They are (1) age, (2) annual income, (3) financialsituation and needs, including the financial resources used for the funding of the annuity, (4)financial experience, (5) financial objectives, (6) intended use of the annuity, (7) financial timehorizon, (8) existing assets, including investment and life insurance holdings, (9) liquidity needs, (10)liquid net worth, (11) risk tolerance, and (12) tax status.

Producers are held responsible for the advice given in relation to the quality of the informationobtained from their clients. It remains the producer’s responsibility to elicit the best responses. Inaddition to discussing the benefits, such as tax-deferred growth, annuitization, or other livingbenefits, producers must reasonably inform the client of the disadvantages, such as surrender periodsand charges; tax implications when the client sells, exchanges, surrenders, or annuitizes an annuity;


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mortality and expense charges; charges for riders, advisory fees, and any limitations on returns,insurance, or investment components; and market risk. Notice how much longer this list is? It shouldbe viewed as a clue as to where the emphasis on suitability now rests.

Page ID: 526347


Be aware that providing incomplete or inaccurate information about taxation matters (from the saleof securities or property to fund an annuity or the taxation of annuity benefits themselves) can leadto serious consequences for producers. The Model Regulation uses phrases like annuity as a wholeand transaction as a whole is suitable to describe one’s interactions with the client. Producers areexpected to know enough about the client’s situation to ascertain if the client will be liquidatingother assets to fund his annuity, and it is always a best practice to make the client aware of the needto consult his professional tax adviser before he proceeds with the sale of any assets.

Page ID: 526348


There are new restrictions imposed if “the consumer has had another annuity exchange orreplacement and, in particular, an exchange or replacement within the preceding 36 months.” If itcannot be demonstrated that a clear and compelling reason to disturb this most recent transactionexists—when the benefits of the proposed sale do not provide a substantial improvement in theclient’s situation, the client will incur a surrender charge; be subject to the commencement of a newsurrender period; lose existing benefits (e.g., death, living, or other contractual benefits); or besubject to increased fees, investment advisory fees, or charges for riders and similar productenhancements—the transaction is likely unsuitable.

However, the regulation does provide producers a measure of protection if their recommendationsare based on inaccurate information from the client, the client refuses to provide suitabilityinformation, or they purchase a product that was not recommended or specifically advised against.To this end, the regulation recommends that producers (1) make a record of any recommendationsmade; (2) obtain a customer-signed statement documenting the customer’s refusal to providesuitability information, if that is the case; and (3) obtain a customer-signed statement stating that anannuity transaction is not recommended if a customer decides to enter into an annuity transactionnot based on the insurance producer’s recommendation. Recordkeeping in this new era of regulationis a must!


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Page ID: 526349


Under the new regulation, insurers are required to properly supervise their agents’ conduct withclients. FINRA also imposes its own set of suitability rules, including the identification of risktolerance, when it comes to transacting variable contracts, and some insurers also require that thosesame suitability tests are applied to transacting FIAs. The regulation permits the FINRA conductrules to take precedence over state law, but FINRA’s rules do not relieve agents of theirresponsibility to the state.

Perhaps the most sweeping change under the Model Regulation is the new requirement prohibitingthe solicitation or sale of any annuity unless the producer has received specific training that provides“adequate knowledge of the product to recommend the annuity and the insurance producer is incompliance with the insurer’s standards for product training.” Insurers must now document that theiragents have completed product-specific training based on standards and materials that fully complywith the regulation before the agents can begin to market any annuity product.

Additionally, there is a requirement to complete a minimum of four hours of continuing education onannuities before a producer may transact annuities with the public. A number of states’ insurancecodes previously included a similar provision, and if the course has already been completed, it doesnot have to be repeated. However, all newly licensed producers must comply with this provisionbefore transacting any annuity.

Page ID: 526350


The regulation allows the state regulator to sanction both insurers and their agents who fail tocomply with the regulation. In addition to appropriate fines or actions against the producer’s license,the regulator may also “order reasonably appropriate corrective action for any consumer harmed bythe insurer, or its producer’s, violation of this regulation.” Some states have inserted the wordsrestitution to the customer as one of the possible corrective actions that may be ordered.

Finally, each state (and FINRA) has its own recordkeeping requirements for transaction records.Agents’ records are open to inspection by the regulators at all times, and it is the producer’sresponsibility to know his state’s recordkeeping responsibilities and adhere to them. FINRA’sConduct Rules generally require that customer files be kept under lock and key! They cannot evenbe left on the desktop when stepping out of the office for just a moment to get a cup of coffee or


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while meeting with someone other than the client or a supervisor who is reviewing the file.

The good news is that most producers have already learned to conduct their business in the mostethical manner and would never consider taking advantage of or deliberately abusing clients byoffering them a product that does not meet their needs. The Model Regulation simply codifies whatis already known to many as best practices.

Page ID: 534944

Activity


Evaluating Customers

Page ID: 526352

Evaluating Customers

Most insurers have already implemented methods of evaluating clients and their need for annuities.Many have prepared entire sales kits that include an application, a variety of required privacy anddisclosure notices, and acknowledgment forms for the client to sign. Some of the forms are requiredto be completed in duplicate, signed by both the producer and the client, with one copy being sent tothe insurer with the application and the other left with the client for his own records.

Remember, there are now 12 evaluation factors (mentioned earlier) that must be identified. Theclient’s response to each of these points, at a minimum, will help determine which of the availableproduct(s) most closely align with the answers given. Obviously, in order to obtain the bestinformation possible, a producer must develop a strong trust bond with the client. Without that, thelikelihood of closing a sale is limited.

Product Knowledge and Training

Page ID: 526354


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Product Knowledge and Training

This area of the relationship between insurers and their agents is going to evolve the most in the nextfew years. As new products are developed, new training will have to precede their releases.Insurance companies are quickly learning the cost advantages of Web-based training modules.Interactive training programs can achieve the same high degree of success (if not higher) that liveseminars or sales training events have provided in the past. When Webinars are conducted live,producers from across the country may attend without having to travel any farther than the distanceto their computer, and they have the opportunity to ask the moderator questions in real time. Thosewhose schedules do not permit attendance during the live program may view a recording at a timemore convenient to them. Through the use of unique login and attendance monitoring features,insurers will be able to document their required training of producers.

Annuity Riders

Page ID: 534947

Annuity Riders

This part of the world of annuities, the riders, will forever be a way to adapt a product line that hasbeen vilified by some and praised by many. While this course presents the topic as a basicfoundation of the various riders, in no way should it be considered the end-all of the discussion ofthese add-ons. To some, the ability to adapt the basic annuity to an individual's current situation islooked at as an opportunity to provide a structure of service, and rightly so; to others, namely theclient, it can be very scary to think of planning for a possibility. That thought, we must foreverconsider, to the client can be so stressful as to render them unable to decide what to do. Our duty,therefore, to that person must rise above any consideration of "self". It also mandates we present thebest possible resolution; what would be the best tool for planning or protecting a particular need. Theresponsibility of the rep is to first understand all the riders available to them and then, adapt or teachthe rider to the client; not the other way around. The client's needs and concerns should alwayscome first.

Suitability of Annuity Transactions

Page ID: 534949


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Suitability of Annuity Transactions

In an attempt to answer the very basic question of "is this annuity suitable for this client?” we mustbe mindful of and answer within ourselves many questions. However, being confident of the solutionbegins with knowledge; ours as a representative but also the client's. If we are to maintain thatconfidence, it many times requires us to educate our client. Before you can teach you must firstlearn. Take time to learn the product and it's variations before attempting to meet your mandate of"suitability." Although they may be used as a short term solution, annuities are most often a verylong term answer and should be used after careful consideration. But, when appropriate, there are nochoices that can match the reliability of a well placed annuity.

Review Test - Not for Insurance CE Credit

1.QID: 447555The primary difference between qualified and nonqualified annuities isA) qualified annuities hold retirement plan assetsB) nonqualified annuities hold pretax contributionsC) qualified annuities earn tax-free interest; nonqualified annuities only earn tax-deferred interestD) qualified annuities are for US citizens, and nonqualified annuities are for noncitizens

2.QID: 447556A nonqualified annuity permits a person to do which of the following?A) Tax-free withdrawal of interest or principal from the account after age 59½B) Withdraw only after-tax contributions at any time prior to age 59½ once the account has beenopened at least 6 yearsC) Contribute a maximum of $5,000 of earned income or $6,000 if over age 50D) Contribute unlimited amounts of money and receive tax-deferred growth of principal and gainsbefore annuitization

3.QID: 447557A fixed annuity offers all of the following EXCEPTA) a death benefit guarantee of principal before annuitizationB) guaranteed payments for life to the beneficiary of the contractC) a guaranteed minimum interest rateD) tax-deferred growth of principal and interest

4.QID: 447558


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What is the primary difference between fixed indexed annuities and fixed annuities?A) Fixed indexed annuity interest rates vary according to the investment results of the S&P 500 fundin the insurer's separate account.B) Fixed indexed annuities offer a guaranteed maximum rate of interest; fixed annuities offer aminimum guaranteed rate of interest.C) Fixed annuities offer a fixed rate of return based on a benchmark index at the time of contractissue, but not less than 3%.D) Fixed indexed annuities offer varying rates of return based on benchmark index performance,with a minimum guaranteed rate of not less than 0%.

5.QID: 447559A variable annuity is characterized by all of the following EXCEPTA) possibility of principal lossB) general accountC) unlimited growth potentialD) separate account

6.QID: 447560Which of these represents the fundamental difference between annuities and life insurance?A) Income for lifeB) Tax-free incomeC) Tax-free annuity death benefitD) Taxable life insurance death benefit

7.QID: 447561Nonqualified annuities and qualified retirement plans share all of the following characteristicsEXCEPTA) penalty taxes on most premature withdrawalsB) unlimited contributionsC) tax-deferred growthD) ordinary income tax

8.QID: 447562An annuity earning 5% will be more valuable over time compared to a CD earning 5% as the resultof what factor?A) Annuity gains are tax deferred.B) CDs are reduced in value by the FDIC insurance premium each year.C) Purchasing power risk is eliminated with annuities.D) Capital gains tax rates apply to annuities but not to CDs.

9.QID: 447563An advantage that nonqualified annuities offer compared to nonqualified multifamily mutual fundaccounts is


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A) tax-free transfers between subaccountsB) ordinary interest rates compared to capital gains tax ratesC) tax-free withdrawal of gainsD) tax-deductible contributions

10.QID: 447564A disadvantage of a nonqualified annuity compared to a nonqualified mutual fund account isA) surrender charges in the early years of an annuity contractB) nondeductible contributionsC) death benefit guarantees of principal to the beneficiaryD) step-up of annuity cost basis following the death of the annuitant

11.QID: 447565Which of the following riders is designed to provide protection against purchasing power risk?A) Long-term careB) Guaranteed minimum withdrawal benefitC) Commuted payoutD) Cost of living

12.QID: 447566Which of the following riders permits the use of annuity value to provide income to an injuredannuitant without annuitizing the contract?A) Cost of livingB) Long-term careC) Guaranteed minimum income benefitD) Disability income

13.QID: 447567Which rider provides a benefit for an annuitant in need of hospice care before the contract is in thepayout phase?A) Terminal illnessB) Guaranteed minimum withdrawal benefitC) Long-term careD) Commuted payout

14.QID: 447568The rider designed to provide income for life to an annuitant without having to annuitize the contractisA) guaranteed lifetime withdrawal benefitB) guaranteed minimum income benefitC) terminal illnessD) guaranteed payout


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15.QID: 447569Which of the following riders allows the annuitant to withdraw additional money from the contractafter it has been annuitized?A) Terminal illnessB) Guaranteed additional withdrawal benefitC) Waiver of surrender chargesD) Commuted payout

16.QID: 447570The purpose of an annuity rider is toA) permit the annuity owner to limit the payments to the annuitant so there will be money remainingwhen the annuitant diesB) extend the value of the contract by including features not part of the basic contractC) restrict the ability of the annuitant to access the contract value prior to annuitizingD) allow annuitants access to their money and avoid taxes

17.QID: 447571When an annuity owner makes an unscheduled withdrawal in the early years of the contract, a______________ may be applied by the insurance company.A) surrender chargeB) policy loanC) penalty taxD) policy dividend

18.QID: 447572It is improper to describe the primary benefit of a fixed indexed annuity in which of these ways?A) A varying interest rate will apply to the cash accumulation, but the rate will never be lower thanthe minimum guaranteed by the insurance company.B) Our annuity offers most of the upside of the index but without the downside risk of negativereturns.C) Our annuity is perfect. It provides all of the upside of the stock market with none of thedownside.D) Cash value accumulation may be enhanced by positive index performance and is protectedagainst negative index performance.

19.QID: 447573An annuity transaction is most likely to be unsuitable whenA) all of the choices are true statementsB) it confers no substantial improvement in the client's situationC) there is no clear and compelling reason to disturb the most recent transactionD) the client will incur a surrender charge or new surrender period

20.


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QID: 447574The NAIC Model Suitability Regulation requires producers to do which of the following?A) Reasonably inform the client of the disadvantages of an annuity, such as surrender periods andcharges and tax implications, when liquidating assets to purchase the annuity.B) Review the client's last 2 income tax returns as a way to identify potential money launderingschemes that frequently target annuity sales. If money laundering is suspected, the producer mustinform the proper law enforcement agency.C) Use the most recent federal and state Do-Not-Call lists to eliminate the possibility of making anuninvited cold call to a person on either of those lists.D) Keep copies of a customer's bank statements for the prior 2 years.

21.QID: 447575At a minimum, the NAIC Model Suitability Regulation requires all producers to do which of thefollowing?A) Complete an initial 4-hour course of instruction in annuitiesB) Complete an initial 6-hour course of instruction in annuitiesC) Complete an initial 8-hour course of instruction in annuitiesD) Complete an initial instructional course in annuities and pass a proctored exam

22.QID: 447576Insurers must now be able to document that their producers haveA) watched another experienced producer close at least 1 annuity transactionB) received specific product training prior to transacting the sale of that annuity productC) expert knowledge of life insurance and annuitiesD) all of the choices are true

23.QID: 447577A producer may be relieved of liability for a customer's unsuitable annuity transaction ifA) the customer purchases an annuity that was not recommended, or was specifically recommendedagainst, by the producerB) the customer refuses to provide suitability informationC) all of the choices are trueD) the customer provides inaccurate or false suitability information

24.QID: 447578It is improper to describe the primary benefit of a fixed indexed annuity in which of these ways?A) Our annuity is perfect. It provides all of the upside of the stock market with none of thedownside.B) Cash value accumulation may be enhanced by positive index performance and is protectedagainst negative index performance.C) Our annuity offers most of the upside of the index but without the downside risk of negativereturns.D) A varying interest rate will apply to the cash accumulation, but the rate will never be lower thanthe minimum guaranteed by the insurance company.


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25.QID: 447579When a scope of appointment notice is required to be given to a senior, it must be deliveredA) by certified mailB) by a disinterested third partyC) at least 24 hours in advanceD) at the time of the appointment

Share Your Thoughts

Page ID: 526276

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