«A n annuity is simply a stream of periodic payments. Start with a lump sum of money, pay it out in equal installments over a period of time until the ...»
n annuity is simply a stream of periodic payments. Start with a lump sum of money, pay it
out in equal installments over a period of time until the original fund is exhausted, and
you have created an annuity. An annuity is simply a vehicle for liquidating a sum of
money. Of course, in practice the concept is more complex. An important factor not mentioned
above is interest. The sum of money that has not yet been paid out is earning interest, and that interest will eventually pass on to the recipient.
Individuals may purchase annuities with a single sum amount or through a series of periodic payments. The insurer credits the annuity fund with a certain rate of interest, which is not currently taxable. Over time, the value of the annuity grows. The ultimate amount that will be available for payout is a reflection of the amount the investor pays into the contract and the interest the insurance company credits to the contract.
With any annuity, there are two distinct time periods involved: the accumulation period and the
payout or annuity period:
The accumulation period is that time during which the contractholder pays premiums into the annuity and the insurer credits interest earnings to the contract. During the accumulation period, the contractholder retains some control over the contract. For example, the contractholder may withdraw funds from the contract, surrender the contract, exchange the contract for a different type of annuity or for a contract issued by another company. The contract will detail what rights the contractholder has during this period and any limitations on those rights. In addition, the IRS may impose limitations or penalties in some circumstances. The accumulation period can last for years, or may be a momentary point in time, depending on how the contract is funded.
During the annuity period, the insurer pays periodic payments to the recipient. The conversion from the accumulation period to the annuity period is referred to as ‚annuitization‛. At this point the contract turns from an investment vehicle to an income-paying device. During that process, the contractholder chooses how he or she would like the annuity payments to be paid out of the contract. Typically, benefits are paid out monthly — though a quarterly, semiannual or annual payouts are possible. There are a number of payout options the contractholder may choose. The amount of an annuity payment is dependent upon three factors: the accumulated principal, interest rate and payment period. Life insurance companies, because of their experience with mortality tables, are uniquely qualified to combine an extra factor – called the survivorship factor — into the standard annuity calculation. Only life insurance companies can guarantee annuity payouts lasting a lifetime.
© 2008 Wall Street Instructors, Inc. No part of this material may be reproduced without the written permission of the publisher.
Annuity Products In some contracts there is no requirement that the contract ever be annuitized, i.e., the accumulation period may continue indefinitely. Other contracts may require annuitization by a certain date or age — this is often called the contract's starting date or maturity date. Some contracts may impose a maturity date, but allow the owner to extend the accumulation period (i.e., delay annuity payments) by giving the annuity company written notice. Regardless of the terms of the contract, once it is annuitized the contractholder loses control over the account, and the company will simply pay the income payments selected by the contractholder.
The distinction between the accumulation period and the annuity period is key to understanding contract provisions and tax treatment.
This course focuses the suitability of an agent’s annuity recommendations and assumes that the student has a basic understanding of annuity contracts. If you would like a more thorough review of annuity contracts, you may access an ‚Annuities Primer ‚ through the online study materials.
Please note: a more comprehensive course on annuities — which also fulfills the senior suitability requirement — is available at www.wallstreetinstructors.com. You may upgrade to the 14-credit “Annuities” course without penalty, please contact our office at 954-764-0254 or email us.
The rest of this chapter will explore the differences between the interest crediting methods of fixed, variable and indexed annuities, fees annuities charge and the tax consequences of an annuity investment.
Interest Credits Fixed Annuities Fixed annuities provide a guaranteed minimum rate of return. The contractholder’s contributions into the contract are placed in the general assets of the annuity company – which invests these payments in conservative, long-term securities (typically bonds). This allows the company to credit a steady interest rate to the annuity contract. The interest payable for any given year is declared in advance by the insurer and is guaranteed to be no less than a minimum specified in the contract. So a fixed annuity has two interest rates: a minimum guaranteed rate and a current rate.
Current Interest Rate
Each annuity company credits the fixed contract with the current rate on a regular schedule, typically each year, but that rate cannot be less than the minimum guaranteed rate. Some contracts guarantee a rate of interest (higher than the minimum rate) for the first years of the contract, after which the current declared rate applies. There are four basic methods annuity companies use to
apply the current interest rate to the contract:
Portfolio Method. This is the most straightforward method — all contracts are credited with the same declared rate regardless of when the contractholder paid the premium into the contract. (New contracts that have a guaranteed rate will, of course, credit interest at the guaranteed rate during the guarantee period.) New Money Method. This method, sometimes called the "pocket of money" method, takes into account the timing of the premium payments. The company will declare an interest rate for the year and all contributions made during that year will be credited with that rate in the future. So a contract may be credited various interest rates depending on when the contractholder made contributions. For example, premiums contributed during calendar year 2007 will earn 3.65%, 2008 contributions earn 3.78%, 2009 contributions earn 3.57%, etc.
Sliding Scale Method. This method credits interest based on the size of the cash value in the annuity — larger balances earn higher rates of interest. For example, the company may declare a current rate of 4.25% for the first $50,000 of cash value, 4.50% for the next $50,000 and 4.60% for cash value in excess of $100,000. Given the fixed costs of administering annuity contracts, smaller contracts are less profitable for the company, and this method takes that into account.
Tiered Interest Rate Method. This method credits different rates of interest depending on whether the contractholder eventually annuitizes the account or surrenders the contract. In these contracts, two different values are disclosed to contractholders annually — the annuity value and the cash (or contract) value. A higher rate of interest is created in the calculation of the annuity value; a lower declared rate is applies to the cash value. If the contract is eventually annuitized, the annuity payments are based on the higher annuity value. If the contract is surrendered, the contractholder receives the lower cash value. The annuity company will continue to profit from a contract that has been annuitized; that profit opportunity evaporates if the contractholder surrenders the contract — hence the company's incentive to encourage annuitization.
Chapter 2 Page 3 Annuity Products
Companies will declare a current rate of interest each year (or another period set forth in the contract). To a certain extent, the term "current rate" is misleading. The rate is not necessarily tied to current market conditions, nor does the company pledge to do so. "Renewal rate" is perhaps a better label. Each "renewal" rate is entirely at the discretion of the company (subject to the minimum guaranteed rate). Some companies declare very competitive renewal rates; others do not. While there is no accurate predictor of how competitive a company’s future rates will be, advisors should review each company's history of interest rate renewals. Some companies in the past have offered special, introductory rates of interest — but as soon as the guarantee period ends, the contractholder find the contract pays little more than the contract's guaranteed minimum rate. There are independent sources advisors can use to ferret out the "bait-and-switch" companies, including A.M.
Best (ambest.com). It is important to note that, in practice, companies rarely credit rates higher than their initial rate. The initial rates that companies offer (which are a key aspect in marketing annuities) will change as market conditions change — but once the contract is established, most companies do not base renewal rates on market conditions.
Some fixed deferred annuities offer a "bail-out" rate. If the renewal rate drops below the bail-out rate, the company will waive any surrender charges — this allows the contractholder to bail out of his annuity position and find other higher-yielding investments without paying a contract penalty.
(Surrender charges and other contract costs are discussed below) Another variation is the so-called "CD Annuity". The type of contract guarantees its initial rate of interest during the surrender charge period (typically the first six years of the contract, or less). Designed as an alternative to bank certificates of deposit, a CD Annuity has a fixed rate of return for a number of years that is tax
-deferred and no surrender charges, if held to "maturity". (For deferred annuity holders under age 59½, there may be a tax penalty for bailing out of the annuity, or if the holder of a CD Annuity is under age 59½ at "maturity".) One popular policy feature available in some deferred annuities is the "bonus" interest rate. This is a rate credited over and above the current renewal rate for deposits made in the first year or first few years of the contract. The bonus interest is immediately vested with the contractholder, that is, there are no strings attached to the extra interest. Companies use the bonus to encourage additional premium contributions to the contract. While bonus interest sounds good, this incentive comes at a cost. Surrender charges on bonus contracts may be higher, interest rate guarantees may be lower or a less advantageous interest crediting method might used — as always, there are no free lunches. Some companies use the same principle to encourage annuitization (vs. surrender or withdrawals), extra interest is credited to the contract if it is annuitized.
When the contract is annuitized, a fixed annuity provides guaranteed income payments of a fixed amount based on the payout method selected by the contractholder. The contract will usually display possible payout in terms of dollars per $1,000 of accumulated value. For example, an annuity promises a 65-year annuitant lifetime monthly payments of $5.06 per $1,000 of value. At age 65 the contractowner chooses to annuitize the account when the annuity had accumulated to $100,000.
The annuitant will receive $506 per month for the rest of his life. This fixed amount is based on an interest rate that is fixed and guaranteed at the point of annuitization. As mentioned above, the contract will initially show minimum payout rates for the various payout options. In the case of deferred annuities, the company may be able to offer higher payout rates at the time of annuitization based on a higher interest rate environment at that time.
Variable Annuities From the contract owner’s point of view, the accumulation of funds in a fixed annuity is certain and the contract owner's principal is secure. The annuity company bears the investment risk. Variable annuities shift the investment risk from the insurer to the contract owner. If the investments supporting the contract perform well (as in a "bull market"), the owner will probably realize investment growth that exceeds what is possible in a fixed annuity. However, the lack of an investment guarantee means that the variable annuity owner can see the value of his or her annuity decrease in a depressed market or in an economic recession.
The distinguishing feature of a variable annuity is the ‚separate account‛, also called the "subaccount". The contractholder’s premium contributions are credited to a separate investment account – not the annuity company’s general account. Historically, separate accounts invested in securities designed to protect against inflation, primarily common stocks. Today, most annuity companies offer a variety of investment options ranging from money market funds to real estatebacked securities. (Most contracts also offer the variable contractholder a "fixed" investment alternative, which mimics the guaranteed interest rate of a fixed annuity.) Contractholders may choose to diversify their investments by directing their premiums into a variety of separate accounts and many companies offer services to periodically reallocate investments within the separate accounts to maintain desired investment balance. The contract owner may also decide to change investments from one separate account to another at little or no cost as market conditions change.
During the accumulation period, the value of the contract will vary according to the investment results in the separate account(s). When the contract is annuitized, and annuity payments begin, the size of those payments will also be based on the investment results of the separate account.
This exposes the annuitant to investment risk. Variable annuity payments are subject to changing market conditions – but that was the intent of variable annuities in the first place. Annuity companies measure changing investment values using accumulation units, which pertains to the accumulation period, and annuity units, which pertains to the income payout period.