The ABC's of Annuity Investing

405 Pages·2011·2.18 MB·English

by  Jason Dietrich

The ABC’s of Annuity Investing

Table of Contents

Table of Contents

I. Retirement’s Surprise 6
Finding Retirement Income 6
Everyone is Living Longer These Days 7
Retirement Risks 8
Baby-Boom Generation Reaches Retirement 10
Putting Off Retirement 11
Gender Issues in Retirement 12
Interest, Dividends and Rental Income / Supplementing SS with Lifetime Annuities 16
Retirement is Expensive 18
How Much Money is Needed to Fund Retirement? 20
Limiting Credit Card Use in Retirement 21
Social Security’s Development 22
Changing the Age of Retirement / Financial Defense 25
Taxation Affects Retirement 26
Tax Efficiency / After Longevity, Health is a Major Retirement Concern 27
The Disappearing Three-legged Stool 28
Diversification 29
Rule of 100 30
Managing the Retirement Money 31
Supplementing Other Retirement Income 33
Annuity Purchase Advantages / Annuity Purchase is not Right for Everyone 34
Practical Application 35
II. Annuity Types 37
The Test of Time 37
The Annuity’s Investment Role 38
Structured Settlements / Annuity Extras; Principal Protection 39
Principal Protection / Premium Methods 40
Annuity Choices / Joint and Survivorship / Guaranteed and Life-Time-Certain 41
Level Annuities / Capital-Back Guaranteed Annuities / Escalating Annuities 42
Inflation-linked Annuities / Enhanced Annuities / The Roth and Education IRA 43
Tax-Deferred Accumulation / Flexibility 44
Annuity History 45
Annuity Basics 48
Choosing Between Fixed and Variable Annuities / Between a Lifetime Annuity and Term Annuity 49
Determining Investment Type 50
Annuity Participants / “Measuring Life” 51
Annuity Terminology 52
Annuity Contracts are “Driven” 56
Meeting Investment Goals 57
How to Sue an Annuity for Losses by Kay Miranda 59
Annuity Investment Advantages 60
Safety of Principal 61

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Reserve Pools / Tax-Deferred Growth 64
Tax-Deferred Defined 65
Tax-Deferred Status 66
Tax-Deferral Exception / Annuity Gifts 67
Annuities are (Sometimes) Protected Assets 68
Probate / Sometimes An Annuity is a Bad Idea: Age & Surrender Penalties 70
Other Tax Issues 71
Death of the Annuitant / 1035 Exchanges 72
Making the Right Annuity Choices 73
So Many Choices 74
Immediate Annuities 75
Split Annuities 76
Single Premium Annuities / Flexible Premium Annuities / Policyowner Risk 77
Variable Annuities 78
Fixed Annuities / Declared Rate Fixed Annuities / Indexed Fixed Annuities 82
Two-Tiered Annuities: Tier 1 and Tier 2 83
Interest Rates 84
Old Money-New Money 85
Interest Rates 87
Price Inflation 89
Measures of Inflation 90
Time Value of Money (TVM) / Issue Age Guidelines 91
Annuity Date / Withdrawal and Surrender Charges and Waivers 92
Chart / “policy term” 93
Premium Payments 94
Contract Administration Charges and Fees 95
ERISA and Tax-Favored Retirement Plans / Using Annuities in Tax-Favored Retirement Plans 96
Group and Individual Annuity Contracts / IRS Requirements for Annuity Funding 97
Taxation of Qualified Annuity Distributions 98
III. Fixed Rate Annuities 100
Annuity Bailout Options 101
Guaranteed Rates of Return / Financial Strength of the Insurer 105
How Fixed Period Annuities Work 106
IV. Equity Indexed Annuities (EIA) 108
Researching the Products 109
Defining the Equity Indexed Annuity 110
EIA Guaranteed Rates of Return 115
Know the Facts Prior to Buying 117
Index Crediting 119
Participation Rates 120
Averaging / Caps 121
Spreads, Margins, and Administrative Fees / Returns 122
Indexing Formulas 123
Annual Reset Indexing Method 124
High Water Mark Indexing Method 125
Point-to-Point Indexing Method 126
Multiple EIAs with Diversified Indexing Methods / Withdrawing Annuity Funds 127
Payout Options 128
EIA Safety 129
A Comprehensive Financial Plan 130
Grasping Fundamental Aspects of the Product 134
Terminology for a Complex Product 136
General Contract Provisions / Entire Contract 139

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Changes and/or Waivers / Misstatements / Required Reporting 140
State Law / Claims of Creditors / Other Contract Items 141
Additional Payments 142
Surrender Values and Penalties / New Developments in Indexed Products 143
V. Variable Annuities 145
Variable Annuity Death Benefit 145
Subaccounts / Immediate or Deferred / Annual Expenses 147
Funding Variable Annuities 148
Variable Annuity Fees / Surrender Fees / Early Withdrawal Tax Penalty / Taxation 149
The Commitment 150
Asset Allocation 151
Asset Allocation Importance 152
Choosing Asset Allocation 153
Analyzing the Asset Allocation Model / Risk & Return / Defining Risk 154
Business risk, Market Risk, Interest-Rate risk and Inflation Risk / Protection Against Inflation 155
Measuring All the Risks (Alpha and Beta) 157
Lifecycle Beta / Living with Risk and Return 158
Managing Sub-Account Strategies / Sub-Accounts 159
Sub-Account Options 160
Performance, Risk Control, Expense Minimization 161
Investment Options, Family Rating, Management 162
Aggressive Growth for Capital Appreciation and for Maximum Growth 163
Growth Sub-Accounts Seeking Capital Appreciation 164
Growth & Income Sub-Accounts Combining Stock and Bonds 164
International Stocks 165
Balanced Sub-Accounts Combining Stock and Bonds 166
Corporate Bond Sub-Accounts Fixed Income 167
Government Bond Sub-Accounts Fixed Income 169
High Yield Bond Sub-Accounts Fixed Income 170
Global & International Bond Sub-Accounts Fixed Income 171
Specialty Portfolios 173
Metals and Utility Sub-Accounts Specialty Portfolios 174
1997 Tax Law Hits Variable Annuities 176
Reallocation of Assets / No Sales Charges / Withdrawals 177
Safety / Reserve Requirements 179
Liquidity 180
Inflation Protection / No Investment Ceiling / Major Variable Annuity Features 181
Moving Money from one Vehicle to Another / Free-Look Period 182
SS Income Exclusion / Investor Control / Professional Money Managers / Unlimited Contributions 183
Commission Charges 184
VI. Annuity Riders 185
Riders and Annuities / Long-Term Care Benefits 185
A Long-Term Care Rider is not a Premium Waiver / GMWB 186
Guaranteed Minimum Income Benefit Rider (GMIB) 188
Guaranteed Minimum Death Benefit Rider (GMDB) / Required Premium / How a GMDB Rider Works 190
Available Benefit Periods / Policy Loans / Life Insurance Riders / What is a Life Insurance Rider? 191
Guaranteed Insurability Rider (Renewal Provision) / Spouse Insurance Rider 192
Accidental Death or Double Indemnity Rider / Waiver of Premium Rider 192
Family Income Benefit Rider / Accelerated Death Benefit Rider / Child Term Rider / LTC Rider 193
Return of Premium Rider / Other Riders 194
VII. Annuitization Options 195
Withdrawal Privilege Options 196
Annuitization Ramifications / Qualified and Non-Qualified Annuity Annuitization 197

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Annuitizing the Contract / Life-time Income, Lifetime and Period Certain, Period Certain 199
Lump Sum, and Joint-and-Survivorship 200
Nonhuman Payees under a Settlement Option / Lifetime Income Payout Option 202
Life Annuity, Period Certain Payout Option 203
Joint-and-Last Survivor Payout Option / Specific Dollar Amount Annuitization / Required Distribution 204
Loan Provisions 205
Guaranteed Principal 206
VIII. Life Insurance 210
Participating Whole Life 210
Interest Sensitive Whole Life / Universal Life / Term Life 211
Indexed Life / Variable Life Insurance Products 212
Variable Life / Variable Universal Life 213
Indexed Life and Indexed Annuities 214
Basic Interest Crediting Strategy / Five-Year Fixed-Term Interest Strategy 215
Five-Year Equity Indexed Strategy / Principal Protection / Annual Lock-In of Earnings 215
Interest Rate Guarantee / Guarantees Among Strategies / Basic Interest Strategy 216
Five-Year Fixed-Term Strategy / Five-Year Equity Indexed Strategy 216
Equity Indexed Life Insurance Loans/Withdrawals 216
Similarities 217
Differences / Paying for the Life Insurance Contract / Single Premium 218
Fixed Premium, Flexible Premium, Premium Load 219
Monthly Life Insurance Deductions 220
Bands in Life Insurance Policies / Consumer Awareness 222
Policyholder Risk / Interest Rate Risk / No Lapse Guarantees or Death Benefit Guarantees Risk 223
Withdrawals 224
Collateral Assignments / Bucket Investing 225
“Laddering” or “Buckets of Income” 226
Strategy Development / Strategies for Buying EI Universal Life Insurance / Over-funding an EI Policy 227
The IRC and Over-funding Life Insurance / TAMRA / DEFRA 228
How to Over-fund Equity Indexed Universal Life Insurance 229
Liquidity Transfer Provisions: Access to Cash Values / Surrenders / Loans / 1035 Exchanges 231
Important 1035 Exchange Procedures 232
Withdrawal Tax Treatment / Income Tax-Free Death Benefit / Internal Buildup 234
Withdrawals of Cash Value / Estate Taxation / Annuities and Taxation 235
Tax Surprises / Withdrawal Impact on Death Benefits 236
To Avoid Surrender Charges, Take a Policy Loan 237
Does the Policyowner Understand the Purchase? 238
Life Insurance Illustrations Model Regulation / Purpose / Authority / Applicability and Scope 239
Definitions 240
Policies to be Illustrated 241
General Rules and Prohibitions 243
Standards for Basic Illustrations / Format 244
Narrative Summary 245
Numeric Summary / Statements 246
Tabular Detail / Standards for Supplemental Illustrations 247
Delivery of Illustration and Record Retention 248
Annual Report; Notice to Policyowners 249
Annual Certifications 250
Penalties / Separability / Effective Date / Compare Equity Indexed Insurance / Insurer Financial Rating 252
Credited Interest Rate / Minimum Interest Rate / Index Cap Rate / Participation Rate 253
Crediting Methods / Segment Periods / Transfer Provisions / Charges / Surrender 254
Loans / Death Benefit Guarantees / Riders / Final Analysis 255
Annual Statements 256

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IX. Insurance Ethics 257
Ethic Subject Matter for Continuing Education 257
Meeting Education Requirements in a Timely Manner 258
The Doctrine of Utmost Good Faith / Breach of Utmost Good Faith 259
Duty of Disclosure / Representations and Warranty / Representations 260
Warranty / Action Taken by Insurer against a Breach / Principle of Waiver & Estoppel 261
Guaranty Association / Rating Companies 262
Knowledge of the Product 268
A Difficult Career Choice 269
It is a Matter of Perspective 270
Establishing Ethical Goals 271
Why Be Ethical? 275
Following the Law / Ethics in the Workplace 276
The Same by Any Name (values and morality) 277
Putting the Past into the Future 278
Personal Values 279
Companies Set Guidelines 281
Promoting Ethical Behavior 287
Is it possible to teach ethical behavior to others? / What is the scope of ethics? 290
What does it take to be a moral person? 291
What quality of work do you want to perform? 292
What do I want my legacy to be? / The Leaders of the Pack 293
What are our responsibilities to other moral persons? 295
Objectivist Ethics 297
Holding on to our Ethical Code 298
Sympathy and Empathy 303
Looking the Part / Courtesy 304
Mores 305
Education 309
Product Knowledge 311
Laying Out Policy Benefits and Limitations 312
Minimizing consumer misunderstandings 313
Policy Replacement / Why would an agent replace their own business? 315
When an Agent Allows Misconceptions 316
When the Client Thinks the Premiums are too High 317
Obtaining Proper Application Signatures / Keeping in Touch after the Sale 318
Selling the “Fast Buck” Item 319
Commingling Funds / The Professional 320
Preparing for Tomorrow / Financial Management 321
Due Diligence 322
If It’s Legal . . . 331
X. NAIC Suitability 335
2010 Suitability in Annuity Transactions Model Regulations 335
Suitability Information / Some Repeated Information / Selecting Appropriate Products 336
What is an Annuity? / Making Decisions 337
Annuities have Many Uses / Safety of Investment 338
Funding Retirement / Structured Settlements 339
Beneficiary Designated Money / Avoiding Probate / Old Money versus New Money Rates of Interest 340
Annuity Participants / Types of Annuities 341
Categorizing Annuities / Benefit Payment: Immediate Annuities 342
Deferred Annuities / Split Annuities / Payment Methods: Single Premium / Flexible Premium 343
Annuity Type Based on Policyowner Risk 344
Variable Annuities / Fixed Annuities 345

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Declared Rate Fixed Annuities / Indexed Fixed Annuities / Two-Tiered Annuities 346
Fixed Rate Annuities 347
Equity Indexed Annuities 350
Variable Annuities 352
Annual Expenses 353
Funding Variable Annuities / Variable Annuity Death Benefit 354
Contract Provisions Affect Consumers / Surrender Values and Penalties 355
Guaranteed Rates of Return (“floor”) 358
Index Crediting 361
Participation Rates 362
Averaging / Caps 363
Spreads, Margins and Administrative Fees / Returns 364
Indexing Formulas 365
Annual Reset Indexing Method 366
High Water Mark Indexing Method 367
Point-to-Point Indexing Method 368
Multiple EIAs with Diversified Indexing Methods / Withdrawing Annuity Funds 369
Payout Options 370
Nonhuman Payees Under a Settlement Option / Lifetime Income Payout Option 371
Life Annuity, Period Certain Payout Option 372
Joint-and-Last-Survivor Payout Option / Required Distribution / Taxation 373
Qualified and Non-Qualified Annuitization 374
ERISA and Tax Favored Retirement Plans / Using Annuities in Tax Favored Plans 375
IRS Requirements for Annuity Funding 376
Taxation of Qualified Annuity Distributions / Financially Sound Insurers 377
State Guaranty Associations / Suitability Standards 379
Determining Suitability 380
Sales Practices / Product Replacement / Deceptive Sales Practices / Full Disclosure 382
Product Knowledge / Identifying Suitability Issues 383
Long-Term; Not Short Use 384
A Comprehensive Financial Plan 385
Tax-Deferred Status 389
Tax-Deferral Exception / Exchanges / Annuity Gifts 391
Other Tax Issues / Annuities Might Protect Assets 392
Probate 393
An Annuity Might be a Bad Idea: Age / Surrender Penalties 394
Grasping Fundamental Aspects of the Product 395
Basic Information Requirements 396
Terminology for Equity Indexed Annuity Products 397
General Contract Provisions 400
Additional Payments 403
This Completes Your Course 404

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Chapter 1: Retirement’s Surprise

Retirement’s Surprise

Finding Retirement Income

The most common problem in retirement is living longer than the money lasts. Of
course, some of this is created by the retirees themselves. They make large purchases
that should not be made from funds that must last throughout their retirement or over-
spend in the early years. Many surveys show a major problem is under-estimating at age
65 how long they are likely to live. Many new retirees plan for twenty years of
retirement living when they should be planning for 30 or more years.

Another error is failing to plan for the effects of inflation and rising costs of living.
Today’s costs will probably be only a fraction of what it costs to live tomorrow. Retirees
must plan on needing progressively more money as the years go by to cover the same
routine bills. Gasoline goes up, electricity goes up, and property taxes go up. Seldom do
any of our routine expenses go down over time. Retirement can be golden but if the
retiree fails to adequately plan ahead with enough savings and investments the final years
may mean poverty.

Many retirees not only miscalculate the amount of money they will need during
retirement, but also make investing errors. For retirees, the margin for error can be quite
slim. Academic research shows investors can afford to withdraw only four to five
percent of their savings annually if they want to be certain their savings will last the 30
years or more they will need supplemented income (beyond Social Security income).1

When stocks perform poorly, annuities gain favor. They are actually the same
consistent performers whether the market is up or down, but when stocks are performing
well annuities look like poor performers since interest rates may be lower than stock
earnings. However, when stocks are down, the interest rates paid by annuities suddenly
look very good to investors and those who advise them.

In 2005, for example, very few people moved their 401(k) funds, IRAs or private
brokerage accounts into annuities at the point of retirement. The reasons vary. In some
cases, it may be that investors think only of life insurance products when they hear
annuities are issued by insurance companies. While annuities are underwritten and

1 U.S. News & World Report 6/13/2005

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Chapter 1: Retirement’s Surprise

issued by life insurance companies, they are not life insurance products. Annuities have
the ability to guarantee a lifetime income, regardless of how long the insured lives. Of
course the amount received will be based on the amount deposited prior to retirement. If
the lifetime payout option is chosen (paying the lifetime income) any unused funds will
belong to the issuing insurance company – not to heirs.

While many financial advisors strongly recommend the lifetime annuity payout option,
investors can select other options so that their beneficiaries will receive any remaining
funds (assuming the investor dies prior to using the total funds invested in the annuity).
However, people are living longer these days. It would be foolish to think of one’s heirs
over the retirement income needs he or she will likely have.

Retirement security is not simply about saving adequately, although that is certainly a
major requirement for a financially secure lifestyle until death. Retirement security is
also about managing the money that was saved. Since many retirees spend too much in
the early years of retirement it is necessary to take steps that will ensure their money lasts
as long as they do. An annuity vehicle does that. By moving his or her savings into an
annuity, annuitizing it for a lifetime income, the investor will receive a set amount of
income each month. In theory this should prevent over-spending in the early years of
retirement. It may also mean giving up the dream of traveling around the world, but in
the end it will provide the security needed during the investor’s full lifetime.

There is one drawback to the lifetime income option: inflation. No matter what happens
in the economy or with inflation, the amount received each month will not vary when a
fixed annuity vehicle is utilized. The monthly income will be the same from the annuity
regardless of where costs go or what the rate of inflation is. Despite that fact, the
knowledge that there will be a monthly income provides a great deal of comfort.

Everyone is Living Longer These Days

Statistics show nearly half of all retirees are unable to meet their regular living expenses
at some point in their retirement. Those with incomes in the bottom 20 percent typically
rely primarily on Social Security to meet their monthly living expenses. This often
means going without needed prescriptions and medical care.

Both men and women are living longer. Individuals who reach age 60 have a very good
chance of living into their eighties and nineties. In addition, the longevity gap between
men and women is closing. Some 20 years ago, a woman aged 60 could expect to live
for another 22 years, while a man of 60 could only expect to live for another 17 years.
Now, a man who reaches age 60 can expect to live for another 21 years and a woman for
another 25 years.

Although the gap is closing, currently the life industry expects women to live longer
than men and so pays women a lower monthly pension amount. People who survive to

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Chapter 1: Retirement’s Surprise

60 are living longer because of improved medical care, a greater willingness to go for
check-ups and medical treatment, better screening for diseases, better education about
diseases and how to treat them, and improved access to treatment. Many feel longer life
is also a product of our increased willingness to stay physically active long into our
retirement.

Coutts-Trotter and Peter Bond, the chief medical officer at Old Mutual Insurance, say
the life expectancy of men has improved faster than women because:
• Men are now smoking less or not at all. In the past it was women who did not
smoke. Women now smoke at nearly the same rates as men.
• Improved medical treatments for heart/circulatory and related illnesses have a
bigger affect on men, who tend to die of these illnesses more than women do.
• Women are suffering from increased stress. More and more women are working
in the formal sector, as well as having to manage the home. The added stress
brought about by women’s changing role in society has had an impact on their
mortality and morbidity. On the other hand, the role of men in society has
remained pretty much unchanged.
• There has been more room for improvement among men, who are now better
educated about health, using preventative measures such as screening to detect
problems at an early stage.2

Although the general population has recognized the fact that they can expect to live
longer than their parents and grandparents did, they do not seem to relate that fact to their
retirement expenses. Living longer means more money is needed to match those
additional years of living.

Retirement Risks

There are many risks associated with retirement. First of all, even with all the
advancements of modern science, we cannot say exactly how long any one of us will live.
Therefore, each person who retires faces “longevity risk.” We also cannot say for sure
where prices will go in the future. We can be fairly sure that prices will go up, but we
cannot say to what extent they will rise. As a result, retirees also face “inflation risk.”
Finally few people entering retirement could predict with accuracy the returns they will
earn on their savings, which is called “investment risk.”

Each retiree can make estimates regarding their longevity by looking at the averages
published by those who study such things and examining their personal family history. If

2 1st quarter 2006 edition of Personal Finance magazine

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Granddad and Dad all lived to be 90 there is the general expectation that the next
generation of men will also reach age 90. In fact, it is likely that following generations
will exceed previous generations since that seems to be the general trend in the United
States and other developed countries. Merely looking at longevity averages would not
tell the full story because averages hide the broad range of experiences. That is why
family history also must be considered. When looking at national averages, about 11
percent of men and 7 percent of women who reach age 65 die prior to their 70th birthday.
On the other end of the averages are those who live to 95 and beyond (6 percent of men
and 14 percent of women). When planning for retirement, it is always wise to consider
ourselves in the group living to age 95 or more since we certainly don’t want to reach age
80 and realize that all our funds are gone. It is the uncertainty of our personal lifespan
that creates longevity risk.

As for inflation risk, even modes price increases erode the value of a fixed income. A
dollar’s value is based on buying power. When a loaf of bread costs $3 upon retirement,
but rises to $5 in five years, the person on a fixed income has, in effect, had their monthly
income reduced. Inflation does not affect everyone equally. Those who want to eat
bread daily have lost buying power but an individual who never eats bread will not notice
its price increase. Some things affect everyone regardless of personal circumstances. For
example, everyone uses electricity so rises in utilities is likely to hit all retirees equally.

Price increases of only 3 percent per year will make $100 of today’s buying values
worth only round $74 in ten years. After 25 years, the value would drop by more than
half to just $45. Those who live to be 95 or more will, therefore, need at least twice as
much income at age 90 than was needed when they retired at age 65. This is an obvious
example of why spending too much too soon in retirement puts retirees into poverty.

When high, often unexpected, rates of inflation occur, those on fixed incomes are
greatly affected. Even when there was planning for inflation unexpectedly high rates can
cause severe poverty.

When sufficient funds were not set aside for retirement there is always the temptation to
try to earn unusually high earnings to offset low saving levels. However, only the young
who are still working should consider high investment risks. Those on fixed incomes or
near retirement are seldom in a position to invest in high risk investments for a simple
reason: there is no time available to make up losses that may occur. High risk
investments are “high risk” for an obvious reason: the investor could lose much of their
investment. This means principle as well as interest earnings. High risk investments
offer the possibility of higher earnings to compensate for the higher risk experienced.
Earnings are uncertain, and the principle is at risk.

Social Security was enacted to help those in retirement, but Social Security was never
meant to completely support the individual. It was assumed that the individual would
have personal savings, a pension, or some other means of added retirement income.

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