CHAPTER 11 ANNUITIES BASIC DEFINITIONS ANNUITANT Not necessarily the person who receives the payments. The annuitant is the person whose life contingency determines the continued payments. ANNUITY CERTAIN Is not based on any life contingency . LIFE ANNUITY
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Not necessarily the person who receives the payments.
The annuitant is the person whose life contingency determines the
Is not based on any life contingency.
Payments are made for the duration of a life.
TEMPORARY LIFE ANNUITY
Payments for a lifetime or for a specified period of time,
whichever is shorter.
minimum living expenses in addition to this social security income.
He has $220,000 to invest but no other assets. He has no need to
leave assets to anyone after his death.
Where should he invest the $220,000?
The scientific liquidation of principal. Each payment is composed of
both principal and interest. Will provide a lifetime income that will be
larger than interest alone.
MONTHLY ANNUITY BENEFITS PER $1,000 OF PURCHASE PRICE
TYPE 65 70 75 80
Life $6.54 $7.47 $8.89 $10.90
10 yr. certain 6.32 6.98 7.79 8.65
Refund 6.18 6.49 7.74 8.90
Example: Age 70, life annuity
$7.47 X 12 months = $89.64
89.65 / 1,000 = 8.96%
1. return of premiums
2. return of interest earnings
3. unliquidated principal of annuitants who die early
LIFE INSURANCE COMPARED TO ANNUITIES
Both protect against loss of income.
Both use pooling.
Both use mortality tables.
Premiums are discounted for interest.
Annuities protect against excessive longevity.
Different mortality tables are used.
Number of lives covered
Most cover one life. A joint life annuity stops payments when the
first of two people dies (seldom used). A joint and last survivor
annuity continues payments when the first dies. May be joint and
2/3 or ½.
Time when benefits start
Immediate annuities start after one payment interval. More than one
payment interval is a deferred annuity.
Method of premium payment
Can be lump sum or periodic payments. Can be flexible deposits.
Most deferred annuities refund all premiums paid,
with or without interest, if the annuitant dies during the accumulation period.
Pure (straight life)
No guarantee. Provides the maximum income.
Life annuity with period certain
5, 10, or 20 years can be guaranteed. The longer the period, the less the income.
At a minimum, payments are continued until the entire purchase price has been received.
At a minimum, the beneficiary receives a lump sum that is the difference
between what has been received and what has been paid. This is
more expensive than an installment refund because the insurer has
the money less time.
This is an installment refund approach but guarantees only 50%
will be received.
Modified cash refund annuity
Used in contributory pension plans. Guarantees a lump sum
refund to the beneficiary to the extent that pension benefits received
are less than the total value of the employee’s contributions
(with or without interest) have been received.
The “normal form” of benefit in a retirement plan is a “Joint and
Client can select a less expensive form of payment (e.g., life
annuity with no guarantees). This will increase retirement
income significantly. Both spouses must sign.
EXAMPLE: Bob and Sue can take $3,000 per month from the
plan as a J & ½ annuity. If they change to a life annuity, their
monthly income can increase $700 per month.
However, if Bob dies Sue’s income will be zero.
Therefore, buy life insurance on Bob that will provide $700
per month for Sue. If the life insurance costs less than
$700 per month they will be ahead.
During the accumulation period, a minimum rate of interest is
Many companies also provide a secondary guaranteed rate for a
period of time (usually several years) which is higher than the
The bail-out provision allows surrender without a surrender charge.
Usually operational only if the interest rate falls below a stipulated rate
(which may be 2 percentage points less than the guaranteed rate). May
not be attractive because rates from other companies probably have
decreased, and because income taxes may be payable on the amount
taken and possibly a 10% premature penalty.
Usually a date or age is set for liquidation but this can be changed. If cash is
taken there is considerable adverse selection and a penalty of some type
probably will be involved (e.g., crediting a much lower interest rate retroactively).
ACCUMULATION PHASE TOTAL
MONTHLY MINUS NET VALUE # ACCUM.
DEPOSIT CHARGES INVEST. OF UNIT PURCHASED UNITS
$1,035 $35 $1,000 $100 10.000 10
$1,035 $35 $1,000 $140 7.143 17.143
$1,035 $35 $1,000 $ 90 11.111 28.254
$1,035 $35 $1,000 $ 50 20.000 48.254
At retirement, they are converted into ________ units and the number of annuity units that will be paid each month does not change. For
example: Suppose a person has 234,555 accumulation units and the annuity factor is 256.444. The person would then receive the value
of 914.6441 units each month. As the value changes each month, the amount of cash sent to the owner would fluctuate.
not on the CPI.
Dividends are usually used to buy additional units.
Variable annuities are securities and are subject to the SEC
(as well as the state insurance departments).
FEES AND ACQUISITION COSTS
1. Investment management fees (.25% to about 1%)
2. Administrative expense and mortality risk charge
Typically about .5% to as much as 2%
3. Annual maintenance charge
About $25 to $100
4. Charges for each fund exchange
$0 to $10
5. Surrender charges
Most variable annuities have an assumed investment rate the portfoliomust earn for the benefit payments to remain level.
If the investment performance exceeds the AIR, the level of benefits will increase. If the investments underperform the AIR, the level of benefits will decrease.
In some contracts, the purchaser is able to select the AIR from a
narrow range of possible rates (e.g., 3, 5, or 7%). It is much easier to receive an increasing stream of benefits by selecting a low AIR.
However, this can be initially more expensive (i.e., the starting
monthly payment will be reduced).
These are fixed, deferred annuities with basic guarantees and limited
participation in equity markets. Theyare fixed-interest annuities.
They guarantee a minimum rate of interest but pay a higher rate if a specified stock index increases enough. They do not require a securitieslicense.
Formula for Participation
They pay only a portion of the capital gain from the index. The insurer
sets the participation rate, which may be as high as 80 or 90
percent. The rate is usually guaranteed for several years. The company
reserves the right to change the rate at the end of each term. The rate
cannot be changed more than once each year in most contracts. The
rate cannot be negative. Some contracts have a cap on the maximum
rate that can be credited. (Often 10%).
There is a connection between guaranteed interest rates and the
percentage participation. Strong participation is usually linked to
lower guarantees and vice versa.
The minimum guaranteed rate is lower than that in conventional fixed
annuities and the guarantee usually pertains only to a percentage of the
amount paid for the annuity. (Usually 90%) Normally it takes 3-4
years for a person to break even.
If the contact is surrendered before the end of a term, the person receives
only the guaranteed interest rate or the total of all premiums minus any
S&P 500 is the most common.
There are 8-10 different methods. The simplest is “point-to-point.”
It takes an index at some point and calculates the gain at a
specified future point. Another is the “high water mark.”
It calculates the gain from a starting point to the highest level
of the index during the period.
How does the company make the contract participate?
The companies match their investments to the index and/or they
Annuitants live longer, hence special mortality tables. Most annuitants
are women. Improved mortality hurts annuity insurers.
They adjust by using mortality tables that have built-in adjustments
for improvements in mortality, by using low interest assumptions, and
by issuing participating contracts.
Amounts taken during the accumulation period (either as loans
or withdrawals) are considered to be withdrawals of growth (earnings)
first (fully taxable) and principal second. In addition, there
may be a 10% penalty tax if before age 59 1/2.
Accumulated value $260,000
Amount paid in 200,000
This withdrawal will be fully taxable.
If $85,000 were taken: $60,000 would be fully taxable and the extra
$25,000 would be treated as a tax-free return of capital.
Exclusion Ratio Formula:
Investment in the contract
“Expected return” is the payments specified X life expectancy
60 year old pays $12,000 for an annuity that will pay him $89.64
per month. His life expectancy is 18 years. How much is
considered taxable income?
$89.64 X 12 months = $1,075.68
$1,075.68 X 18 years = $19,362
$12,000 / 19,362 = 61.98%
The exclusion ratio is 61.98%
$89.64 X .6198 = $55.56 is considered a return of principal
The remainder, 89.64 – 55.56 or $34.08 per month is taxable
This amount, $34.08 will be taxed at ordinary income rates.
After the entire investment is returned the total benefit will be taxed. With a joint and survivor annuity, the surviving owner excludes from income the same percentage of each payment that
was excludible by the first annuitant.
With a variable annuity it is impossible to determine the expected return
because there is no specified payment.
Different exclusion ratio:
Investment in the contract
# of years of expected return
1. When a person want a retirement income that can never be outlived.
2. When safety of principal is important.
3. When an individual wants a monthly income equal to or higher than other conservative investments and is willing
to (or especially if he wants to) have principal liquidated.
4. When the person want to avoid probate and pass a large
sum of money by contract to an heir to reduce the possibility of a will contest.
5. When a tax-deferred accumulation is desired.
6. When the investor want to be free of the responsibility of investing and managing assets.
7. As a supplement to an IRA (where contributions are limited).
8. The client can “time” the receipt of income and shift it to
lower bracket years.
1. The owner is too young.
2. The annuitant is not in good health.
3. Withdrawals before age 59 ½ may incur the 10% penalty tax
4. Liquidation in the early years could be expensive
5. Investment earnings are taxed at the owner’s ordinary income tax rate (not the long-term captial gains rate that
would apply to mutual funds)
6. If the annuity owner dies, the heirs will be taxed on the
earnings in the same way the owner would have been
taxed had he lived. In contrast, mutual funds in a taxable
account pass to the heirs free of income taxes because
of the “stepped up” cost basis.
7. Fees, especially in variable annuities, may be high
8. If the owner is not a natural person (e.g. a corporation or
trust), income is currently taxed (no inside tax free build up)
Client enters into a contract to donate cash or other assets to a charity.
In exchange, the charity agrees (in the contract) to provide a lifetime
income to the donor.
The gift is irrevocable; therefore an immediate income tax deduction
is provided to the donor. The deduction is the difference between
the value of the assets and the present value of the annuity income.
Annuity payments may be annual, monthly, or whatever. Only a
portion of the annuity payment is taxable because part is a return
of the taxpayer’s gift.
Annuity rates (not income tax rates) are negotiable but most use
the rates of the American Council on Gift Annuities. Many states
require charities to maintain adequate reserves to meet annuity
obligations. If the donor lives long enough, the charity may not
realize any net benefits from the gift. If the donor dies soon, the
transaction will be very profitable for the charity. The financial
strength of the charity is very important.
Takes into account the annuitant’s decreased life expectancy.
Some annuities contain a long-term care rider.
Large court judgments or settlements are often paid as a
negotiated income, which can be provided by an annuity. A
liability insurance company normally arranges a structured
settlement by buying an annuity from a life insurance company.
A lump sum payment for a personal injury is generally tax-free,
but earnings on the invested lump-sum are taxable.
With a structured settlement, income is tax free IF the claimant
has no ownership of the annuity and no constructive receipt.
Even the interest on the contract is tax free.
The annuity may be flat rate, step rate or increased as some
compound annual rate. The periodic payment schedule
cannot be changed. Income guarantees (e.g. refund annuity)
can be used.
Ongoing regular medical treatments
Adequate income to replace wages that can no longer be
Ongoing household help
Occupational therapy and rehabilitation
Educational needs of children
Payment of legal fees
Trusts, endowments and annuities to take care of dependents
Factors to consider in determining the amount and terms
of a structured settlement include:
The life expectancy of the claimant
The likely cost of future medical expenses, rehab, therapy, etc.
Cost of reasonable living expenses
Cost of dependents needs
Lump sums for special contingencies
structured settlement broker may shop several insurers to get
the highest payment.
ADVANTAGES OF A STRUCTURED SETTLEMENT
1. Income can be tailored to the needs of the recipient.
2. Income can be set up to last a lifetime.
3. Periodic income takes the worry out of the process.
Recipient loses control of the money. (Many people take only a
portion of their money as a structured settlement).
The sale of a structured settlement is free of federal income taxes.
To qualify there must be a court order to sell the agreement. If
there is no court order a tax of 40% is required. (40% of the
difference between the settlement amount and the total of the
undiscounted future payments).
Some people think they can earn a higher return than the return
implicit in the settlement.