share – Share variable annuity contracts credit an additional amount to the contract value, which is calculated as a percentage of purchase payments added to

the contract at or subsequent to contract issue. This category does not include contracts that credit additional amounts to the contract value after a designated period, sometimes referred to as “persistency bonuses.” There are ongoing M&E and administrative fees, which tend to be higher than B-Share contracts.

According to Morningstar Inc., B-shares were the most popular type of surrender charge based on VA Share Class Distribution (Non-Group New Sales) for year-end 2012 (see Table 4.3). Surrender charges underscore the long-term nature of the annuity product.

As long as contract owners remain committed to accumulating money for retirement through their variable annuity, they generally will not incur these charges. A number of insurers have begun to offer other types of charge structures to meet different investor needs.

Table 4.3

VA Share Class Distribution Non-Group New Sales Data 2012

Source: Morningstar and Annuity Intelligence Metrics, Advanced Sales &

Marketing Corp, 4^th Quarter 2012; LIMRA March 2013

Premium Tax

A few states impose premium taxes on variable annuity purchases. These taxes range from 0.50% - 5.0% depending on the state of residence but in most cases do not exceed 5% (see Table 4.4).

A-Share 3.2%

B-Share 52.8%

C-Share 3.2%

L-Share 25.8%

X-Share 6.7%

Multi-share 7.4%

No Load 0.9%

Table 4.4

States Charging a Premium Tax on Annuities

State

A variable annuity offers a wide range of investment options for the contract holder (owner) to invest their premiums in various sub-accounts. To assist the contract holder in their investment strategies the VA contract also offers various investment features such as dollar cost averaging, fund transfers, asset allocation strategies and automatic portfolio (asset) rebalancing.

Dollar Cost Averaging

Dollar cost averaging may reduce an individual’s concern about making an investment at the “wrong” time. Investors sometimes delay the purchase of a security whose price has been rising rapidly because they feel that it may be due for a correction. Meanwhile the price continues to rise and they lose what had been a good opportunity to buy. Or they may delay the purchase of a security whose price has been falling because they fear it may be in a long-term downward trend.

Dollar cost averaging alleviates this problem. With dollar cost averaging, an individual invests the same flat dollar amount in the same securities at regular intervals over a period of time, regardless of whether the price of the securities is rising or falling.

 If the price of the security rises, the investor cannot purchase as many units of that security for the same flat dollar amount. However, the value of the investment as a whole will have risen. And if the price of the security later falls, the fewer units purchased at the higher price will not drag down the total return on the investment as much as if a large lump sum had been invested at the higher price.

 If the price falls, the value of the investment also falls, but the investor is able to purchase more units of those securities. If the price of the units later rises, the larger number of units purchased at the lower price will more quickly offset the loss in value caused by the earlier decline.

Dollar cost averaging does not offer a guarantee of gain or a guarantee against loss. But over time it helps to average out the highs and lows in the security’s price, and that frees the investor from the anxiety of trying to predict the long-and short-term price swings that can fool even the most experienced investor in many cases.

With all that said, there are several financial experts who argue that DCA does not work.

In an article in the October 2006, “Journal of Financial Planning”, John G. Greenhut, Ph.D., writes that:

“…the behavior of stock volatility, which has given rise through illustrations to the widespread belief that dollar-cost averaging, allows more shares to be bought over time than would occur through a lump-sum investment. We have exposed that illustration as a mathematical illusion, based on arithmetic changes in a denominator leading to disproportionate changes in the fraction.”

Fund Transfers

A variable annuity will allow the annuity contract holder to transfer funds from one sub-account to another (subject to some restrictions) tax-free. This flexibility to reposition investments under the umbrella of the variable annuity offers the annuity holder the opportunity to change his or her investment focus. It also allows an annuity holder to change the level of risk that he/she is willing to accept. However, most contracts do have some limitations on transfers. They are:

 May limit the frequency of transfers by stipulating that they must be separated by a certain interval such as seven or thirty days.

 There may be a minimum dollar amount or percentage of sub-account value that is being transferred, and a minimum dollar amount or percentage of value that must remain in the sub-account.

 Some contracts limit the number of transfers that may be made each year. Some contracts have no limits, but reserve the company’s right to charge a fee.

 Because fixed account guarantees are supported by investments that may have to be liquidated at a loss to accommodate a transfer, limits on the timing and amount of transfers from the fixed account are common.

Asset Allocation

Asset allocation involves the use of a number of different investment options, each of which plays a role in meeting the contract holder’s overall financial goals. It also involves adjusting the percentage of assets devoted to each investment option to increase

the chances that the contract holder’s goals will continue to be met as circumstances change.

The essence of asset allocation is to establish a mix of investments to match a contract holder’s financial objectives and risk profile, and to change that mix as expectations change in regard to the returns available in each class of investments. Some contracts offer asset allocation services which will move the owner’s money according to a professional asset manager’s assessment of the outlook for stocks, bonds, interest rates, and so on. Under some other contracts, this is established by allowing the money manager to make the appropriate transfers in the owner’s sub-accounts. Other contracts offer an asset allocation sub-account in which the money manager changes the mix of various investments on an on-going basis in an attempt to achieve the next favorable return.

Asset Rebalancing

Asset rebalancing is a technique used by many portfolio managers to reduce risk and improve a portfolio’s overall return. It involves making security trades at certain intervals in order to bring the asset mix back into line with the allocations originally determined for the portfolio. In effect, the portions of the portfolio that have performed the best are reduced so that additional assets can be purchased for the portions of the portfolio that have performed the worst.

There are no guarantees, of course, that automatic asset rebalancing will improve a contract holder’s return, nor does automatic asset allocation provide any assurances against the chance that the value of the securities underlying the investment option may fall.

Guaranteed Minimum Death Benefit

A common feature of variable annuities is the death benefit. The contractual payout of the death benefit varies by contract. The death benefit is generally payable as a lump sum payment or as an annuity payment. Variable annuity contracts have traditionally offered a guaranteed minimum death benefit (GMDB) during the accumulation phase that is generally equal to the greater of:

 The contract value or

 Premium payments less prior withdrawals.

The GMDB gives the contract owners the confidence to invest in the stock market, which is important in order to keep pace with inflation, since we know that their family will be protected against financial loss in the event of an untimely death.

Enhanced Death Benefits

Over the past ten years, many insurers have offered enhanced death benefit riders. Some type of enhanced death benefit is now available with most variable annuity contracts.

There are three types of enhanced death benefit riders. They are:

 Contract Anniversary (Market Anniversary Value) or Ratchet

 Initial Purchase Payment with Interest or Rising Floor (Roll-up)

 Enhanced Earnings Benefit

These different types of enhanced GMDBs are riders to the contract and will have additional associated charges. The charges could be applied to the contract value or benefit base. Generally, these optional death benefit riders can only be elected at issue if the owner(s)/annuitant(s) are within the age specifications as set forth in the contract rider and prospectus and are irrevocable once elected. Let’s review each of these enhanced guaranteed minimum death benefits in greater detail.

Contract Anniversary, Or “Ratchet”

Some insurance companies offer ratchet GMDBs that are equal to the greater of:

 The contract value

 Premium payments less prior withdrawals

 The contract value on a specified prior date

The specified date could be a prior contract anniversary date such as the contract anniversary date at the end of every seven-year period, every anniversary date or even more often. A ratchet GMDB locks in the contract’s gains on each of the specified prior dates.

Initial Purchase Payment with Interest or Rising Floor

Some insurers offer rising floor or rollup GMDBs that is equal to the greater of:

 The standard death benefit, or

 The purchase payments accumulated at a specified annual rate (5% - 7%) up to a specified age and adjusted for any withdrawals.

In some cases, a combination contract anniversary value and a rising floor may be available within the same contract: By stepping up the increasing Death Benefit to the Account Value may start over a new surrender charge period.

For Example: Mr. Jones purchased a $100,000 variable annuity with a surrender charge of 5 years. Over the years Mr. Jones owned the contract, his account value jumped around from $150,000 to $250,000. At the end of the five years, Mr. Jones’

surrender charges had expired and the value of his account was $200,000. At that

time, Mr. Jones locks in his step-up death benefit to the account value of $200,000.

In exchange, the insurer restarts another 5-year surrender charge penalty schedule.

Of course, these types of increasing death benefits do not last forever. Most contracts call for the suspension of the increasing death benefit at ages from age 75 to age 85, depending on the contract.

In some cases, a ratchet and a rising floor may be available within the same contract.

Some contracts offer a choice of a ratchet or a rising floor.

Enhanced Earnings Benefits

Some insurers offer enhanced earnings benefits (EEB), which provide a separate death benefit that can be used, for example, to pay the taxes on any gains in the contract. With this feature, beneficiaries will receive not only the death benefit amount, but also an additional amount, which is usually equal to a percentage of earnings.

Guaranteed Living Benefit (GLB) Riders

Since their inception in 1996, guaranteed living benefit (GLB) riders have become increasingly common in sales of VA contracts. In 2012, about 87% of all variable annuity contracts sold came with a GLB rider, according to Morningstar.

GLB riders attached to a variable annuity can be offered as one of the following:

 Guaranteed Minimum Income Benefits (GMIB),

 Guaranteed Minimum Accumulation Benefits (GMAB),

 Guaranteed Minimum Withdrawal Benefits (GMWB), and

 Guaranteed Minimum Withdrawal Benefit for Lifetime (GMWBL).

According to LIMRA, VA GLB Tracking Survey (November 2013), in the 3rd quarter of 2013, the rate of election for GLBs was 81% down from 90% in the 4^th quarter 2012. In the 3^rd Quarter of 2013, GLB riders were elected in contracts representing 65% of total VA sales ($19.0 billion out of $26.7 billion). VA assets with GLB riders increased to

$650 billion from $530 billion at the end of the 4th quarter of 2011.

The GMIB and GMAB election rates in 3^rd Quarter 2013 continue to decrease, whereas GMWBL election rates increased seven percentage points, when compared with the 3^rd Quarter of 2012. The GMWBL is the most elected GLB rider (66%), and the GMIB is second at 12% (see Table 4.5).

Table 4.5

GLB Election Rates (When any GLB available)

GMWBL GMIB GMAB GMWB 66%

12%

2% 1%

Source: LIMRA Retirement Research, November 2013. Note: Hybrid election rate less than ½ of 1%.

Guaranteed Minimum Income Benefit (GMIB)

The GMIB was the first living benefit rider that hit the market back in 1996. What it’s designed to do is guarantee the client (contract holder/annuitant) a future income stream.

The VA-GMIB has two values: a Contract Value and an Income Benefit Base. The GMIB payment will be based on the Income Benefit Base and the annuitization factor.

GMIB Features and Benefits

One of the important features of the VA—GMIB rider is how the income credit accumulates. With the GMIB rider, the income credit accumulation can continue whether or not the client (annuity holder/owner) makes a withdrawal. This is different than most GMWB’s/GMWBL’s contracts, where the credit accumulation stops once you commence withdrawals (discussed below).

For Example: If the accumulation rate of the GMIB is 5%, then you can take any amount up to 5%. Whatever you don’t take out continues to accumulate in the Income Benefit.

Credit accumulation ends when the age limit (usually age 85/91) is reached or when annuitization occurs.

Another important feature of the GMIB is annuitization. When your client purchases a GMIB rider, their future annuity rates are stated in the prospectus. These rates are generally lower than the life annuity rates in the open market.

It does this via its income base or bases. Today, GMIBs may have both a roll-up base, which increases annually from 4-5 percent depending on the insurance company, and a

GMIBs also have a waiting period in which the benefit cannot be exercised. This period ranges from five to ten years depending on the insurance company and benefit.

Something to keep in mind is that some insurance companies will require your client to restart the waiting period if you lock in a new value for the step-up base.

GMIBs are available at contract issue, provided the oldest annuitant is not over the age specified in the rider and the prospectus at issue (usually, ages 70 or 78). GMIBs are irrevocable, optional living benefits that provide a safety net for retirement assets in the form of a guaranteed minimum income stream—no matter how the underlying annuity investments performs as long as no withdrawals are taken.

To receive the income benefits from the rider the client must annuitize the contract under the terms of the contract. Note: The guaranteed payout rates with the GMIB are based on conservative actuarial factors and are currently less favorable than the current payout rates used to convert contract values to annuitization income. In other words, there is a

“haircut” on the GMIB annuity actuarial factors.

GMIB Caveats

The following are some of the caveats of the GMIB rider:

 A set waiting period (usually 7-10 years)

 Maximum age required for annuitization age 80 - 91.

 May require Asset Allocation /Immunization strategies

 To benefit greatly the difference between the guaranteed amount and the actual account value must be substantial

 Must annuitize the contract with the insurer GMIB Client Suitability

The following would be individuals who the guaranteed minimum income benefit rider may be suitable:

 Client looking for a lifetime income stream and wants to maximize security above all other considerations.

 Individual plans to annuitize their contract.

 Owner/annuitant cannot be over a specified age set forth in the contract.

Guaranteed Minimum Account Balance (GMAB)

The GMAB rider offers a guarantee of principal while remaining invested in the market after a specific waiting period usually five to ten years. Be aware that there may be conditions and restrictions on this benefit. Most variable annuities using the GMAB come with prepackaged asset allocation models into which you place the premiums invested in the contract by the contract holder. Today, many insurers now offer access to a wider

range of investment options so that your client can design a strategy specific to their needs and timelines. Some contracts now offer target maturity date funds in their portfolios, making the job that much easier.

What’s important with this feature is that the benefit base is a walk away amount. Your client does not need to annuitize the contract.

As of the 3^rd quarter of 2012, approximately 2.0% of VA contracts purchased elected a form of GMAB rider.

GMAB Example

A client invests $100,000 in a variable annuity with a GMAB feature. After 10 years the contract holder has taken no withdrawals and the market value has dropped to ½ of its original value, or $50,000. With the GMAB rider, the account is returned back to the benefit base of $100,000, the original principal, and because no withdrawals were taken during the 10-year period the contract holder could then surrender the contract and receive $100,000.

GMAB Caveats

The following are some of the caveats of the GMAB rider:

 Some GMAB contracts mandate that all assets be allocated in specified investment options (asset allocation models) to access the benefits.

 Some contracts allow the insurer to change the client’s allocation at their discretion and the client has no control over the investment choices.

 At the end of the waiting period, the benefit may be exercised, expired, or renewed, depending on terms of the contract.

 If the benefit is not exercised or renewed, the guaranteed amount will be subject to market risk and may lose value.

 If benefit is renewed it will start a new waiting period.

GMAB Client Suitability

The following individuals who the guaranteed minimum accumulation benefit rider may be suitable:

 Clients who are seeking protection against unpredictable markets.

 Clients who have a number of years before they will need the money, and

 Clients who are not seeking a death benefit or looking to convert their contract to income (annuitize).

Guaranteed Minimum Withdrawal Benefit (GMWB)

The GMWB rider was the second type of GLB, it evolved in 2002 in response to some of the limitations posed by the GMIB, especially during bull markets. The idea behind the GMWB is to allow the contract holder to withdraw a maximum percentage of their total investment each year for a set number of years, regardless of market performance, until recovery of 100% of the investment. The insurer can be defined as a rider that guarantees a fixed percentage–generally 5% (some contracts may be higher) of the annuity

premiums can be withdrawn annually for a specified period of time until the entire amount of paid premiums have been withdrawn, regardless of market performance and without annuitizing the annuity.

GMWB Example

A client invested $100,000 into a variable annuity with a GMWB with a 5% systematic withdrawal; the contract holder could withdraw $5,000 per year for 20 years regardless of market performance. If the contract holder’s account value went to zero before the 20 years were up, the contract holder would continue to receive the $5,000 for the remainder of the 20-year benefit period. You calculate the benefit period by taking the benefit base and dividing it by the percentage of the dollar-for-dollar withdrawal. Here in our

example, a 5% dollar-for-dollar withdrawal would give the client a benefit period of 20 years.

GMWB Caveats

The following are some of the caveats of the GMWB rider:

 Owner/annuitant cannot be over a specified age (usually age 70 or 75) as set forth in the contract rider.

 Owner/annuitant cannot be over a specified age (usually age 70 or 75) as set forth in the contract rider.

In document ANNUITY CONTRACT STRUCTURE, TAX LAWS, AND SUITABILITY (2014 Edition) (Page 49-67)