Annuities Table of Contents

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Annuities

Chapter One

Introduction to Annuities and Annuity Buyers

Important Lesson Points

The important points addressed in this lesson are:

√ Annuities offer contract owners substantial tax benefits, including tax deferral of

earnings and partially tax-free income benefits

√ Annuities may be classified as fixed or variable, deferred or immediate, or

qualified or non-qualified

√ Although non-qualified annuity buyers may come from all economic strata, the

majority of annuities are purchased by middle income individuals

√ Non-qualified annuity buyers purchase annuities for a number of reasons,

principal of them are as a retirement income supplement, a safe-haven investment, a survivor income or to provide a financial safety net in the event of illness

√ Annuities were initially vehicles designed solely to systematically liquidate a

principal sum over a lifetime

√ Modern annuities are purchased more frequently for their accumulation

advantages than for their distribution characteristics

Introduction

Annuities offer their owners the opportunity to systematically liquidate a principal sum or save money for a long-term objective. For many annuity buyers, that objective is to provide income during retirement. As we will see in our examination of annuities, they provide owners with a number of advantages; principal among them is their tax treatment. By purchasing and investing in an annuity, a contract owner can avoid current income taxation of earnings. By avoiding current income taxation, earnings that might have been used to pay current income taxes can be invested to produce additional income.

Annuities’ tax advantages aren’t limited to tax deferral, however; annuities offer additional tax advantages. For example, an investor purchasing a variable annuity can change his or her investment allocation in the contract’s variable subaccounts whenever desired. Typically, such changes are made in order to implement new objectives or to modify the level of risk assumed. From a tax point of view, the important issue is that the contract owner can make these changes without being required to recognize income as would be required if, for example, the investor liquidated his or her stock portfolio in order to purchase bonds. In addition to these tax benefits, a contract owner that elects to annuitize his annuity contract, i.e. to take a periodic income from it, will find that part of each periodic income payment may be tax free as a return of his or her investment in the annuity contract.

It will become apparent as we continue to examine annuities that they may be distinguished from one another in a number of ways. Annuity contracts may be:

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Fixed or variable Deferred or immediate

Single premium or flexible premium and

Qualified or non-qualified

Although we will briefly discuss qualified annuities, this course’s principal focus will be on non-qualified annuities, i.e. annuities purchased outside of any advantaged plan such as a tax-sheltered annuity or individual retirement account.

Demographics of Non-Qualified Annuity Purchasers

Who buys non-qualified annuity contracts? Since annuity contracts offer some interesting tax benefits, we might expect that individuals with substantial incomes and assets would be the predominant buyers. That belief, at one time, was shared by certain members of Congress, who professed an interest in reducing some of the annuity’s tax advantages. Although it might be reasonable to conclude that annuities are a vehicle only for the rich, that conclusion would be incorrect.

Following the announced intention by Congress a decade or more ago to review the tax benefits afforded annuity owners, periodic surveys began to be commissioned in order to determine who purchases them. Over the time that these surveys have been done, the answer to that question has not varied substantially. Somewhat surprisingly, perhaps, the market for non-qualified annuities is comprised principally of middle-income purchasers, although affluent investors also buy them. The income and asset distribution of families in America shown below indicates that approximately 92 percent have earned incomes of less than $100,000; it is that group that constitutes the bulk of non-qualified annuity buyers.

Household Income & Assets

Percentage Distribution

Distribution by Number of Households

(millions) Income

Under $75,000 83.8 85.9

$75,000 – 99,999 7.7 7.9

$100,000 – 199,999 6.2 6.3

$200,000 and over 2.3 2.4

Financial Asset Level

Under $250,000 90.1 92.4

$250,000 – 499,999 5.2 5.3

$500,000 – 999,999 2.5 2.6

$1 – 4.9 million 1.9 1.9

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In addition, studies indicate that almost one-half of these non-qualified annuity buyers are or were retired business owners, corporate officers or professionals, while fewer than 20 percent were blue collar or service employees.

With respect to the ages of non-qualified annuity owners, studies indicate that a substantial percentage—30 percent by some estimates—are age 72 and older. There are certain buying differences that were observed between individuals that owned declared-rate annuities and those that owned variable annuities or equity-indexed annuities. The first fixed annuity contract was purchased by individuals younger than age 50 in about 41 percent of contract owners. However, buyers of variable annuity contracts tended to buy at a somewhat earlier age. Fifty-three percent of annuity owners bought their first variable annuity before they were age 50. Buyers of equity indexed annuity contracts were also about 7 years younger than declared-rate annuity buyers. Despite the obvious tax benefits that would appear attractive to wealthier investors, some advisers believe that the affluent generally avoid investing in annuities. That opinion isn’t supported by the demographic findings. Although slightly less than 6 percent of households overall own an annuity, about three times that percentage of individuals earning $200,000 or more own them. As might be expected, the percentage of annuity ownership and the median annuity value tend to

increase as household income and net worth increase.1_{The Federal Reserve Board’s}_{Survey of}

Consumer Finances, published in January 2000, categorizes annuity ownership by income and asset levels as shown in the chart below.

Household Income & Assets

Percentage Distribution Of

Annuity Ownership

Median Value Of Annuity Owned Income

All families 5.7 $ 30,000

Under $75,000 5.0 26,000

$75,000 – 99,999 6.2 28,000

$100,000 – 199,999 10.9 60,000

$200,000 and over 17.1 70,000

Financial Asset Level

Under $250,000 4.4 $ 18,000

$250,000 – 499,999 13.9 69,000

$500,000 – 999,999 20.1 95,000

$1 – 4.9 million 23.3 70,000

$5 million and over 17.4 131,000

It also appears that, irrespective of the income and asset category of the annuity purchaser, the funds invested in the annuity were the result of individual earnings rather than an inheritance.

1_{James O. Mitchel, “Finances of the Affluent: Special Analysis of the Survey of Consumer Finances,”}

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Why Buyers Purchased Non-Qualified Annuities

The available studies have provided some insight into the demographics of a non-qualified annuity buyer. Let’s consider why they purchased their annuities. Four reasons are offered for most non-qualified annuity purchases. Those reasons are:

1. For a supplemental retirement income

2. To provide funds, if needed, to purchase care following the onset of a serious illness

3. To provide a safe investment haven in the event other investments perform poorly

4. For an income to a survivor, e.g. a widow or widower

A Gallup survey, reported in a June 4, 2001 National Underwriter article,2_{underscores these}

purchase motivations. According to the National Underwriter article, eight in ten annuity owners

interviewed identified three principal motivators leading to their non-qualified annuity purchase: To use the annuity income as a financial cushion if the owner or spouse lived

beyond their life expectancy To avoid being dependent on children

and

To ensure a retirement income

It is interesting to note that, while retirement income was an important motivator for many non-qualified annuity buyers, few annuity owners used the annuity funds. Instead, 90 percent of the annuity buyers responding still owned the first annuity they had bought, and only thirty percent of annuity owners had withdrawn funds from the annuities they owned.

Many annuity owners fear depleting their funds and becoming dependent. For that reason, many people beyond retirement age try to live entirely on their investment income or interest from their savings and avoid invading principal.

The Annuity Concept

The term “annuity” hearkens back to a Greek word, annus, which means “year” and connotes an

annual income payment. As initially conceived, an annuity is simply a product that, through annual payments, systematically liquidates a principal sum over a lifetime. In its traditional meaning, an annuity offers a benefit that can’t be found in any other financial vehicle; that benefit is an income that cannot be outlived, no matter how long-lived the individual is.

Think of how important that might be. Suppose that you were age 65 and had a sum of money with which to live the remainder of your life—$300,000, for example—and could not obtain additional funds under any circumstances. You could invest your principal in a money market account and live off the interest that was earned. At 4 percent, your annual income would be about $12,000; however, since you did not invade the principal, you would never run out of money. Unfortunately, the income you received wouldn’t provide much in the way of luxuries and probably not very many necessities either.

Since that approach doesn’t provide sufficient income for you, you decide to look up your life expectancy in the actuarial tables and find that at age 65, your life expectancy is approximately

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21 years. By doing a few calculations, you determine that you can increase your annual income to $20,000 by withdrawing an increasing amount of principal each year. At that rate, and assuming you continue to earn 4 percent on the balance, the principal will last for exactly 21 years.

Because $20,000 isn’t sufficient to maintain your lifestyle, you decide to try to increase your earnings on the principal, knowing that by placing your funds in investments that can produce a higher income you will be risking the loss of the principal. However, if you can increase your earnings on the principal, you can take annual withdrawals of $25,850 each year and not exhaust the principal until the end of 21 years. Based on that reasoning, you decide to move your principal out of the money market account and invest it in high yield bonds, also known as junk bonds.

But, what risks have you taken? The risk that immediately comes to mind is that the junk bonds may lose their value if interest rates increase, and since these high yield bonds have a low rating the issuer may be unable to meet the interest and principal payments at some time in the future. The more significant risk, however, relates to your lifespan. If you live longer than the actuarial table says you are likely to, your income will cease entirely. The additional risk that you have assumed is the risk of outliving your money.

The alternative, of course, is to purchase an annuity. At age 65, the monthly income that you can purchase per $1,000 of principal ranges from about $7 to $10, depending upon the insurer from

which it is purchased.3_{In other words, your $300,000 of principal can be applied to purchase a}

single premium immediate annuity that pays you an annual life income between $25,200 and $36,000. And, even if you live longer than the 21 years that the actuarial table considers your life expectancy, your income will continue. Furthermore, if you used a variable annuity, your income could increase over time to make up for the erosion of your purchasing power due to inflation. Although this example illustrates the traditional use of an annuity—as a vehicle to systematically liquidate a principal sum—it doesn’t go far enough. In today’s economy, annuities are used frequently as a vehicle in which to accumulate the fund that will be used to provide a retirement income. Let turn our attention now to how modern annuities work.

Annuities in Operation

Earlier in this Chapter it was noted that annuities can be categorized in a number of ways, including as a deferred or immediate annuity. In the example posed just above, the investor would have placed his $300,000 in an immediate annuity, since he was interested in having his income begin right away. Many people, however, prefer to make regular premium payments to their annuity and build up the fund over time. That kind of annuity is called a “flexible premium deferred annuity” (FPDA) and is the kind of annuity that we will be spending most of our time discussing.

In an FPDA, the contract owner makes premium payments to an insurance company. The insurance company credits the premium payment to the cash value of the owner’s contract. Depending on how the cash value is invested, the annuity contract will be either a fixed annuity or a variable annuity. For now, our assumption is that the annuity is a fixed annuity to which the insurer credits interest annually.

There are three parties to an annuity contract. Those parties to the contract are the:

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Contract owner Annuitant

and Insurer

The contract owner is the person that owns the contract, pays the premiums and has certain rights, including the right to name a beneficiary to receive any survivor benefits. The annuitant is the person whose life governs the duration of life annuity periodic payments. In the majority of cases, the contract owner is also the annuitant; however, the contract owner and annuitant need not be the same person.

The period before the annuity starting date and during which the contract owner is paying

premiums on the annuity contract is known, appropriately, as the accumulation period. In an

FPDA, the contract owner may make premium payments as regularly or irregularly as desired and, within certain limits, in any amount chosen. Usually insurers require that any payment made meet a certain minimum amount, such as $25; similarly, an insurer may limit the amount of any individual premium paid to no more than $250,000. The minimum premium requirement is imposed to enable the insurer to avoid costly premium administration involving small amounts. The maximum premium limitation may be imposed to ensure that the insurer is able to make a timely investment of the premium payments.

During the accumulation period, the contract owner may take withdrawals from the annuity. However, a surrender charge may be applied if the withdrawal is taken during the surrender

period. Premium payments cease on the annuity starting date. That is the date on which periodic

income payments are scheduled to begin. Periodic income payments continue throughout the

annuitization period or payout period.

Summary

The annuity contract that initially provided only for the systematic liquidation of a principal sum over a lifetime has become a highly competitive financial vehicle for the accumulation of funds as well as for their distribution. Offering buyers significant tax benefits, annuities may be classified as fixed or variable annuities, deferred or immediate annuities, qualified or non-qualified annuities, and as single premium or flexible premium annuities.

Although non-qualified annuity buyers may come from all economic strata, the vast majority of annuities are owned by middle income individuals with annual incomes of less than $100,000. These individuals purchase their annuities principally for four reasons: to provide supplemental retirement income, to provide a financial safety net in the event of a catastrophic illness, to be a safe haven in the event that other investments perform poorly, and to provide a survivor income.

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Chapter Two

Characteristics of Annuities

Important Lesson Points

√ Annuities may be funded by single premiums, fixed level premiums or flexible

premiums

√ Insurers generally impose a fee on annuity contract owners for expenses of new

business acquisition, record maintenance, accounting and reporting

√ Variable annuity contracts typically have higher fees than fixed annuities,

generally reflecting their more complex nature

√ Surrender charges may be imposed for annuity withdrawals or surrenders during

the early contract years known as the surrender charge period

√ Annuities may cover a single life or multiple lives

√ The most popular multiple-life annuity is a joint and survivor annuity, often

covering spouses

√ In a fixed annuity the insurer bears the risk of principal loss; in a variable

annuity, the contract owner generally bears that risk

√ Insurers credit fixed annuities with interest periodically; variable annuity cash

values are based on the performance of the variable subaccounts to which the premium is allocated

√ Periodic annuity income payments may be made under temporary annuities or

life annuities

Introduction

Annuities, as noted earlier, come in a variety of types: fixed, variable, deferred, immediate, non-qualified and so on. Despite that variability, there are certain common characteristics of virtually all annuities. In this chapter we will look at these common characteristics.

Premiums

Premiums paid for annuity contracts may be of three types:

1. Single premiums

2. Fixed level premiums

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Single Premium Annuities

Single premium annuity contracts are annuities in which only one premium is envisioned. Generally no further premiums are either expected or permitted. Often, single premium annuity contracts are funded by money received from an employer’s qualified plan—a pension or profit sharing plan—or as a result of a severance package received from a terminating employer. Sometimes, of course, single premium annuity premiums come from inheritances or an individual’s certificate of deposit. Single premium annuities may be either single premium immediate annuities (SPIA) or single premium deferred annuities (SPDA).

Level Premium Annuities

Annuities are sometimes funded through fixed level premiums. Under this approach, the contract owner pays a regular premium at fixed intervals, i.e. monthly, quarterly, semi-annually or annually, much as he or she would pay a whole life insurance premium. Normally, the contract owner does not have the option of paying more or less than the billed premium. Fixed level premiums characterize traditional retirement annuity contracts. While fixed level premiums provide a certain compulsion to accumulate funds through a forced savings approach, this premium-paying method has largely given way to flexible premiums.

Flexible Premium Annuities

The most popular method of funding an annuity is through flexible premiums. In a flexible premium annuity, the insurer sends regular premium notices on the chosen frequency to the contract owner who may remit the billed premium, more or less than the billed premium, or no premium at all. (There are, typically, certain minimum and maximum premiums permitted by the insurer.) Under the flexible premium approach, the contract owner may pay a premium when his or her cash flow permits and pay no premium when it doesn’t. This popular premium-paying method has supplanted, for the most part, the less-flexible fixed level premium approach.

Whether the annuity premiums are paid on a fixed, level basis or on a flexible basis, annuities on which ongoing premiums are paid may only be deferred annuities; single premium annuities, however, may be either deferred annuities or immediate annuities.

Annuity Expenses

Annuity expenses differ, to some extent, depending upon whether the annuity contract is a fixed annuity or a variable annuity. Regardless of whether the contract is a fixed annuity or a variable annuity, however, the insurer may impose a level sales charge, taken from each premium before being credited to the contract’s cash value. Sales charges generally enable the insurer to recover its expenses of acquiring the new business and, in the case of annuities, are principally commission and other distribution expenses. In addition to sales charges, the insurer may levy a charge for record maintenance, accounting and reporting.

Surrender Charges

It is possible that a contract owner may elect to withdraw funds from a fixed or variable annuity contract or surrender it entirely before the insurer has been able to fully recover its sales charges. In such a case, the insurer generally charges the contract owner a withdrawal or surrender charge. Surrender charges apply only during the surrender charge period and usually (although not always) reduce over the period. Although insurers are generally able to impose surrender charges

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at any level, typical surrender charges for a flexible premium deferred annuity are levied as a percentage of the amount withdrawn as shown below:

Contract Year 1 2 3 4 5 6 7 8 and later

Surrender Charge 7% 6% 5% 4% 3% 2% 1% 0%

M&E Charges and Investment Advisory Fees

While sales and record keeping expenses may apply to either fixed or variable annuity contracts, there are certain expenses that are normally found only in variable annuity contracts due to their generally greater complexity. These additional variable annuity expenses include:

• Mortality and expense risk charges (M&E)

and

• Investment advisory fees

Let’s consider the M&E charges first. Insurers selling variable annuities face two mortality risks. Those risks are that:

Annuitants will live longer than anticipated based on mortality statistics and

The death benefit guaranteed in the contract will exceed the value of the annuity at the time of the contract owner’s death

In addition to these two mortality risks, the insurer also faces an expense risk: that it will be more costly to administer and distribute the variable annuity contracts than it assumed. Both of these risks are charged for in the insurer’s M&E charges. M&E charges are deducted from the separate account.

Investment advisory fees charged provide the payment for investment advisory services provided to the funds that comprise the separate account. The investment advisory fees are charged at the fund level, rather than at the separate account level and are generally higher for funds that are more complex and lower for funds that are simpler. Accordingly, investment advisory fees are higher for higher for international funds or for stock funds (.7% - 2% annually) than for money market funds (.3% - .6%).

Lives Covered by the Annuity

Up to this point in our examination of annuities, discussion has centered on an annuitant and a

contract owner. Based on that, it might be reasonable to conclude that an annuity may cover only one individual. That is not the case.

Multiple Life Annuities

Although annuities involving only a single life predominate, annuities covering two lives are also popular. There are two types of annuities covering two lives: a joint life annuity and a joint and survivor annuity. While there need exist no familial relationship between the two individuals that are included under an annuity that covers two lives, the most common arrangement is one that covers a husband and wife.

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A joint and survivor annuity is a life annuity under which an income continues until the last of the two covered individuals dies. As we will discuss more fully when we examine annuitization methods, the income provided under the joint and survivor annuity may or may not decline following the first death. Although the arrangement for continuing income after the first of the two annuitants dies may be anything agreed to by the annuitants and the insurer, the most common income arrangements provide the following percentage of income to the survivor:

100% 75% 66 2/3% 50%

The two reasons that generally cause annuitants to select a reduced income benefit after the first death are:

1. Living expenses may be expected to reduce when one of the annuitants dies and

2. The income provided under the joint and survivor annuity while both are alive will be higher if the survivor income is lower

Married participants in qualified retirement plans are required to take a benefit from them that is a qualified joint and survivor annuity under which the participant’s spouse would receive an income benefit of at least 50 percent of the benefit payable while both are alive. The spouse may, of course, waive that right.

The second type of multi-life annuity is known as a joint life annuity. Under this arrangement, all income benefits cease upon the first of the two annuitants to die. Although such an income arrangement may have application in certain unusual circumstances, it is not nearly as popular as a joint and survivor annuity.

When Payout Begins

We noted that annuities may be classified as deferred annuities or immediate annuities. The difference between the two may be obvious, but it is reasonable to spend a few minutes discussing the differences.

Deferred Annuity

A deferred annuity is an annuity under which periodic income payments are deferred to, i.e. delayed until, some date in the future. That future date, i.e. when periodic income payments are

scheduled to begin, is known as the annuity starting date. The period between the time that the

annuity is purchased and the annuity starting date is the accumulation period.

A deferred annuity is an annuity under which a period longer than one payment interval must elapse before the first benefit payment is due. As a practical matter, however, a period of several years often separates the annuity-purchase date and its annuity starting date. A deferred annuity may be funded by a single premium or by periodic premiums.

In a typical situation, a 40 year-old non-qualified annuity buyer might decide to pay monthly premiums of $250 for an FPDA. When the contract owner reaches age 65, he or she might reasonably expect to have an accumulated value in the annuity of about $140,000, depending on the interest rate paid over the years of the accumulation period.

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Immediate Annuity

Unlike a deferred annuity, an immediate annuity is one in which the first periodic income payment is due one income payment interval after the date that the annuity was purchased. For example, if the immediate annuity provides for annual periodic payments, the first income payment would be due one year after the immediate annuity was purchased. If the annuity provides for monthly periodic income payments, the first payment would be due one month following the date that the immediate annuity was purchased. Immediate annuities are only funded by single premiums.

Annuity Type First Periodic Payment Premium Options

Immediate annuity One income payment interval

following purchase

Single premium only

Deferred annuity More than one income

payment interval following purchase

Single premium or periodic premiums

Cash Value Accumulation

The words “fixed” and “variable” have been mentioned several times in the discussion thus far. It is time that some definitions are attached to these labels.

Fixed Annuities

A fixed annuity is one under which the insurer, rather than the contract owner, bears the risk of loss of principal. The insurer guarantees the contract owner that:

• Principal will not be lost, regardless of the insurer’s investment

performance and

• Interest at least equal to a stated minimum rate will be credited

Although insurers guarantee to credit interest at a rate at least equal to a stated minimum in a

fixed annuity, they may—and usually do—credit interest at a higher rate, known as the current

rate. The insurer may credit interest in a fixed annuity in excess of the guaranteed rate based on:

• The interest declaration made by the insurer’s Board of Directors

or

• The performance of a particular index

If the fixed annuity credits an interest rate based on the insurer’s declaration, it is known as a

declared-rate fixed annuity. If the fixed annuity credits an interest rate based on a particular

index, such as an equity index or interest index, it is known as an equity indexed annuity or an

interest indexed annuity, respectively. We will examine both of these approaches to crediting current interest in a later chapter.

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Unlike a fixed annuity, in which the insurer bears the investment risk, contract owners of variable annuities bear the risk of loss of principal to the extent that the variable annuity premiums are allocated (by the contract owner) to the insurer’s separate account. To the extent that the variable annuity premiums are allocated to the separate account, the accumulated value of the variable annuity depends upon the performance of the variable subaccounts to which the premiums are allocated. In a variable annuity, the contract owner may allocate his or her premiums to the:

• Separate account

or

• Fixed account

The insurer’s separate account is generally comprised of several variable subaccounts that are usually differentiated from each other by objective and risk level. Although any insurer’s separate account may have many variable subaccounts, a separate account will usually offer the variable annuity contract owner the opportunity to allocate premiums to a:

• Common stock portfolio

• Bond portfolio

or

• Money market fund

In addition to allocating variable annuity premiums to the separate account, the contract owner may choose to allocate some or all of his or her premiums to the variable annuity contract’s fixed account. The fixed account is similar to a fixed annuity to the extent that the insurer guarantees both the principal and a minimum rate of interest. The accumulated value of a variable annuity at any time is equal to the value of the separate account and the value of the fixed account.

Some variable annuity contracts provide for the allocation of premiums to the separate account only during the accumulation period; other variable annuity contracts permit both variable accumulation and variable payout.

Variable Annuity Premium Allocation to Fixed and Separate Account

Contract Owner

Separate Account

Fixed Account

Stock Variable Subaccount

Bond Variable Subaccount

Money Market Variable Subaccount

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Death Benefits

Death benefits payable in an annuity contract depend on whether the contract owner/annuitant dies before or after the annuity starting date. If death occurs after the annuity starting date, any benefit payable to a beneficiary will depend on the type of annuity selected as well as on the presence of any refund or guarantee period, as discussed in the next section entitled “Annuitization Methods.”

Basic annuity death benefits payable if death occurs before the annuity starting date are equal to the greater of the premiums paid or the cash value. In the case of a fixed annuity, the contract’s cash value will always be equal to or greater than the total of the premiums paid, since the owner is guaranteed against loss of principal and the insurer regularly credits interest. In a variable annuity, because the value of the cash value may go up or down depending on the performance of the variable subaccounts to which the premium is allocated, the guarantee that the death benefit will never be less than the premiums paid is an important one.

We will discuss variable annuity death benefits in greater depth in the next chapter when we examine variable annuities. At that time, we will look at some of the competitive innovations in the product’s death benefit, including a periodic step-up.

Annuitization Methods

When the contract owner purchases an immediate annuity or the deferred annuity contract reaches the annuity starting date, the owner must decide on the annuitization method, i.e. how the periodic income is to be paid out. There are two basic methods of annuitization, depending on whether or not life contingencies are involved:

Temporary annuity or

Life annuity

Temporary Annuity

A temporary annuity is an annuity in which no life contingencies are involved. In other words, the payout is not affected by whether or not the annuitant dies. There are two types of temporary annuities:

1. Fixed amount annuity and

2. Fixed period annuity

A fixed amount annuity is a temporary annuity under which a principal sum plus interest is liquidated and each payment is a specified, level amount. When the principal and interest have been liquidated, the payments cease whether or not the annuitant is alive. If the annuitant dies before the entire principal and interest have been liquidated, the balance is paid to the annuitant’s beneficiary.

A fixed period annuity is a temporary annuity under which level income payments are made for a specified period. At the conclusion of the specified period, income payments cease, whether or not the annuitant is alive. If the annuitant should die before the end of the period, income payments continue to the annuitant’s beneficiary until the period ends.

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Life Annuity

We noted that a temporary annuity is an annuity that does not involve life contingencies. A life annuity, by definition, is an annuity involving life contingencies. The annuitant is the measuring life in a life annuity. Although the annuitant need not also be the contract owner, in the vast majority of cases, they are the same person.

In the basic life annuity—generally known as a straight life annuity—periodic income payments

are made for the annuitant’s entire life, whether the remaining lifetime is measured in months or

decades. However, if the annuitant receives at least one periodic payment and then dies, no

further payments are due. For example, assume that a 65 year-old man purchases an immediate straight life annuity for $1 million and elects to receive monthly periodic payments. His monthly payments are likely to be between $8,000 and $10,000 monthly. If he should die after receiving only one $8,000 income payment, no other payments would be made to anyone else, and his annuity premium would become a part of the insurer’s general assets.

Annuitants sometimes object to the loss of their annuity premium if they should die after receiving only a single periodic payment. An annuitant that wants to receive periodic life annuity payments but also wants to be sure that a guaranteed minimum is paid out has two choices:

1. A period certain or

2. A refund annuity

Under either approach, the insurer guarantees that an income will continue for the annuitant’s entire life, no matter how long that life is. It also guarantees, however, that a certain minimum amount will be paid.

Under a life annuity with a period certain, the insurer promises to pay an income for the life of the annuitant, but if the annuitant should die before a particular period—the period certain—ends, payments will continue to a beneficiary for the balance of that period. For example, suppose an annuitant owns a life annuity with a 10 year period certain. If the annuitant lives for 30 or 40 years, payments will continue until he or she dies. If the annuitant were to die at the end of 8 or 9 years after beginning to receive income payments, however, the payments would continue for the remainder of that 10 year certain period to the annuitant’s beneficiary. A period certain may be for as short as 5 years or as long as 25 or 30 years. The longer that the period certain is, the lower the periodic life income is.

A refund annuity is somewhat similar to a period certain insofar as it guarantees that a certain minimum amount will be paid, regardless of when the annuitant dies. There are two types of refund annuity:

1. A cash refund annuity and

2. An installment refund annuity

In a cash refund annuity, the insurer guarantees that if the sum of the periodic income payments received by the annuitant does not at least equal the amount of the annuity purchase price at the time of the annuitant’s death, the difference will be paid in a lump sum to the annuitant’s beneficiary. For example, if the annuitant had paid $100,000 for an immediate cash refund annuity and died after receiving a total of $25,000 in periodic payments, a payment of $75,000 would be made to his or her beneficiary.

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In an installment refund annuity, the insurer guarantees that if the sum of the periodic income payments received by the annuity does not at least equal the amount of the annuity purchase price at the time of the annuitant’s death, income payments will continue to a beneficiary until the difference is paid. For example, suppose that the annuitant paid $100,000 for his or her installment refund annuity and was receiving a monthly periodic payment of $1,000. If the annuitant died after receiving 75 payments, the beneficiary would receive the $1,000 monthly payments for an additional 25 months.

Although the actual amount of monthly life annuity benefits payable per $1,000 of premium is affected by the prevailing interest rate, the following monthly life income amounts purchased by a $100,000 premium for the different types of annuities will offer some insight into their relative cost to the annuitant.

Type of Life Annuity

Monthly Income Male Age 75

Straight life annuity $1,282

Life annuity with 10-year period certain $1,094

Refund annuity $1,155

Although this discussion of life annuity guarantees has been couched in terms of single-annuitant contracts, the concepts and the guarantees apply equally to joint and survivor annuities. In other words, the two annuitants under a joint and survivor annuity may opt for a straight life annuity under which payments cease upon the second death, or they may elect a period certain or a refund annuity.

Summary

A contract owner may choose to fund his or her annuity contract—whether a fixed or variable annuity—on the basis of a single premium, fixed level premiums or flexible premiums. Although fixed level premium annuities provide greater benefit guarantees, contract owners have generally preferred the convenience and lack of compulsory payments offered by flexible premium annuity contracts.

Annuity contracts generally require the contract owner to pay fees to enable the insurer to recover its costs to acquire the business, i.e. principally sales and distribution expenses, as well as fees for record maintenance, accounting and reporting. Variable annuities, in addition to these fees that generally apply to all types of annuities, impose additional fees reflecting the increased costs associated with administering this more complex product. Insurers normally impose surrender charges in the early years of the contract in order to enable them to recover the balance of any new business acquisition costs in the event of early termination or withdrawal.

Annuity contracts may be written to cover a single life or multiple lives. The most popular multiple-life annuity is a joint and survivor annuity. Although joint annuitants need not be related, the most popular joint and survivor annuity is one covering spouses. A joint and survivor annuity provides an income benefit until the last of the two annuitants dies. Qualified retirement plans require that a married participant take his or her retirement benefit in a joint and survivor annuity unless the participant’s spouse agrees to forgo this guaranteed survivor income.

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The principal difference between a fixed annuity and a variable annuity relate to the different means by which the cash value grows. In a fixed annuity the issuing insurer periodically credits the cash value with interest based on a declared rate or on the performance of a specified index. In a variable annuity, cash value growth depends upon the performance of the variable subaccounts to which the annuity premium is allocated. That difference in cash value growth leads to an important difference with respect to risk: in a fixed annuity, the insurer bears the risk of principal loss; in a variable annuity, the contract owner bears that risk.

On and after the annuity starting date, income benefits are payable. Annuity income benefits may be paid under a temporary annuity—either a fixed period annuity or fixed amount annuity—or a life annuity. If paid under a life annuity, the contract may or may not provide for benefits to be paid to a survivor depending on the contract owner’s election.

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Chapter Three

Variable Annuities

Important Lesson Points

√ Variable annuities combine the characteristics and risks of traditional investment

products with the features of an annuity

√ The variable annuity contract owner selects an asset allocation at the time of

application and may change it when needed

√ Variable annuity contracts give owners the opportunity to manage the volatility

of cash value through various no-cost options such as automatic subaccount re-balancing

√ Variable payouts enable annuitants to overcome the purchasing power erosion of

their income caused by inflation

√ Variable annuity suitability for a customer, in addition to meeting traditional

suitability criteria, must meet special suitability requirements related to variable products

√ In addition to a life insurance license, an agent must have a Series 6 or Series 7

registration and a state securities license in order to sell variable annuities

Introduction

An investor can attempt to meet his or her financial objectives through the purchase of a variety of investments. Investments that may be used to meet objectives include stocks, bonds, money market instruments and mutual funds. Variable annuities combine many of the characteristics and risks of these investments with the features of an annuity.

We examined the characteristics of annuities in chapter two. Generally, except for the guaranteed interest rate found in fixed annuities, a variable annuity has similar characteristics. Instead of receiving interest however—other than with respect to funds placed in a Fixed Account—the cash value of a variable annuity depends on the investment performance of the variable subaccounts to which the contract owner has allocated premiums.

Fixed annuities are supported by the insurer’s general account that is generally invested in bonds and other fixed income securities. Variable annuities are invested in the insurer’s separate account, an account that is segregated from the insurer’s general account and comprised of several variable subaccounts differentiated by objective, risk level and underlying portfolio. Accordingly, the return enjoyed by a variable annuity will fluctuate based on the performance of the variable subaccounts in which the owner has invested premiums.

Since separate accounts are not governed by state insurance law requirements for secure, fixed income securities, a separate account can be funded with common stocks and other more-volatile securities—similar to a mutual fund. Also similar to mutual funds, separate accounts are

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managed by professional investment advisers. These advisers are paid a fee based on a percentage of the assets they manage.

Separate account investment returns are comprised of the same four elements that normally make up mutual fund returns:

• Dividends

• Interest

• Realized gains and losses

and

• Unrealized gains or losses

In the separate account, unlike a mutual fund, all earnings are automatically reinvested and credited to the account. The value of each variable subaccount is computed daily, and the contract owner's interest is equal to the number of accumulation units owned multiplied by the value of each unit.

Similar to fixed annuities, a variable annuity may be purchased as a:

• Single Premium Deferred Annuity (SPDA)

Flexible Premium Deferred Annuity (FPDA) and

Single Premium Immediate Annuity (SPIA)

Deferred Annuity Accumulation

During the variable annuity’s accumulation phase, the contract owner selects the variable subaccounts to which his or her premium is allocated and the amount or percentage allocated to each. The owner chooses the variable subaccounts and percentages at the time of application for the annuity. These selections may be changed by the owner at any time. The variable subaccounts offered generally include the following, although many other options may be offered:

A money market subaccount in which allocated premiums are invested in short-term money market instruments selected with the objective of achieving the maximum current income consistent with reasonable safety of principal and liquidity

A stock subaccount in which allocated premiums are invested in common and preferred stock in order to achieve capital appreciation

A bond subaccount in which allocated premiums are invested in investment grade bonds selected with the objective of achieving a high level of income over the long term consistent with reasonable safety of principal

When the contract owner has selected the variable subaccount or subaccounts in which to allocate the annuity premium, the annuity’s cash value fluctuates from day to day based on the performance of the accounts selected. One of the very important features of a variable annuity is the contract owner’s ability to transfer funds between variable subaccounts and to change the allocation of premiums as desired. This enables an owner to modify his or her investments in order to reflect current market conditions, and changed objectives and risk tolerance.

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For example, suppose Jim Whittaker has a flexible premium deferred variable annuity to which he contributes $1,000 each month. His allocation and account values are currently as follows: Subaccount

Percentage of Premium Allocated to Subaccount

Current Subaccount Value

Stock subaccount 50% 12,000

Bond subaccount 30% 9,000

Money market subaccount 20% 4,000

Jim believes that stock prices are going to be taking a downturn and transfers his funds in the stock subaccount to the bond account. Simultaneously, Jim changes the allocation of future premiums so that 50% of premiums are allocated to the bond account and 50% to the money market account. Insurers normally restrict the number of no-cost fund transfers a contract owner can make in his or her contract in one year and may charge a nominal fee for subaccount transfer exceeding 12 in a year.

The value of a variable annuity is determined by multiplying the number of accumulation units by the value of each unit. When a contract owner pays premiums on a variable annuity, the insurer typically deducts any sales charges and allocates the net amount of the premium in the variable subaccounts selected by the owner. The number of accumulation units purchased by the allocation of premium will depend on the price per unit of that variable subaccount at the end of the business day.

For example, suppose that George Wilson purchases a $30,000 single premium deferred variable annuity and allocates 50% to the stock subaccount and 50% to the bond subaccount. The number of accumulation units George owns is determined as follows:

Subaccount

Premium

Allocation ÷ Value Per Unit =

Number of Accumulation Units

Stock $15,000 ÷ $7.30 = 2,054.8 units

Bond $15,000 ÷ $5.70 = 2,631.6 units

At any future date, George's annuity value is equal to the value of one accumulation unit at that time multiplied by the number of units he owns. For example, one year later, George's annuity is worth:

Subaccount Unit Value x Units Owned = Accumulation Value

Stock $7.00 x 2,054.8 units = $14,383.60

Bond $6.50 x 2,631.6 units = $17,105.40

Total = $31,489.00

Because the stock subaccount unit value declined, the value of George's stock subaccount similarly declined, from $15,000 to $14,383.60. However, since the unit value of the bond subaccount increased the value of George's bond account also increased from $15,000 to $17,105.40. Taxation of these earnings is, of course, deferred until those earnings are actually distributed to George or his beneficiary.

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Managing Cash Value Volatility

The decision to purchase a variable annuity contract is normally motivated, at least in part, by the buyer’s desire to participate in possibly greater cash value growth by investing in the contract’s variable subaccounts. What may keep some prospects from purchasing a variable annuity, however, is cash value volatility; simply stated, the ups and downs of the stock market may keep otherwise suitable buyers from investing. There are several tools that can enable the contract owner to enjoy the potential cash value growth possible with an investment in securities while minimizing the cash value volatility that is also characteristic of equity investment. The tools available in a variable annuity that can assist the owner in variable subaccount management include:

• Diversification _• Dollar cost averaging

• Asset allocation _• Interest sweep

• Automatic asset re-balancing _• Variable subaccount transfer

While recognizing that not all insurers will offer all of these tools, let’s examine each of them and their operation in the variable annuity contract.

Diversification

Diversification refers to the inclusion of a number of different investment vehicles in a portfolio in order to increase returns or reduce risk exposure. The variable annuity contract owner may diversify by including several different investment vehicles in a portfolio. By diversifying, the owner may increase the portfolio’s return or decrease its risk exposure. Variable subaccounts are diversified, of course, in much the way that mutual funds are diversified. However, the owner may provide further diversification by selecting multiple subaccounts in which to invest. Insofar as the variable subaccounts are negatively correlated, i.e. one tends to go up when another goes does, the diversifiable risk to which the variable annuity contract is subject is reduced. By reducing the risk to which the cash value is exposed, the separate account’s volatility is reduced.

Asset Allocation

Asset allocation involves dividing one’s portfolio into various asset classes in order to preserve capital by protecting against negative developments while still taking advantage of positive developments. Although asset allocation is similar to diversification insofar as its objective is to reduce risk and preserve capital, asset allocation and diversification are not identical. The focus of diversification is on investing in various vehicles within an asset class; asset allocation’s focus is on investment in various asset classes. In the process of asset allocation, the contract owner divides his or her investment among asset classes such as U.S. stocks, U.S. bonds, foreign securities and so forth. This is designed to produce a mix of assets that is suitable for the contract owner in view of his or her risk tolerance and investment objectives.

Although the terms “conservative,” “moderate” and “aggressive” change depending upon who is using them, asset allocations for these different contract owners could approximate those shown below:

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Variable Subaccount Conservative Moderate Aggressive

Common stock 15% 30% 40%

Bonds 45% 40% 30%

International 5% 15% 25%

Money market 35% 15% 5%

Total 100% 100% 100%

As the contract owner’s risk tolerance moves from low risk to high risk, the allocation of assets also moves from conservative—with an emphasis on fixed-income securities—to aggressive, with a correspondingly higher allocation to common stock and international subaccounts.

Automatic Subaccount Re-balancing

Successfully employing asset allocation requires that the allocation remain in place for an extended period; that generally means for at least 7 to 10 years, provided the owner’s objectives and risk tolerance have not changed during that period. The cash value management tool known as automatic subaccount re-balancing maintains that allocation. This tool automatically reallocates the assets among subaccounts periodically in order to maintain the owner’s pre-selected percentage allocation among the variable subaccounts. Although not usually available on a monthly basis, this re-balancing can be scheduled quarterly, semi annually or annually and is normally provided without additional charge.

Fund Transfer

We have already noted that variable products enable contract owners to change their subaccount allocation without the need to recognize income for tax purposes. This facility to re-allocate funds from one variable subaccount to another allows the contract owner to actively manage his or her asset allocation and reduce subaccount volatility.

Dollar Cost Averaging

Dollar cost averaging is a well-known and workable strategy. When employed within a variable annuity contract, it enables a contract owner to average the cost of shares over the purchase period by systematically transferring fixed dollar amounts from one subaccount to another subaccount. Dollar cost averaging enables an investor to obtain an average cost for shares purchased that is below the average price for the shares in a fluctuating market.

In a typical situation, a contract owner could use funds invested in the money market account to purchase shares in the stock account, and each month the insurer would automatically transfer a set amount from the money market account to the stock account. Usually, insurers require that a minimum amount be transferred and that the contract have a minimum cash value in order to establish dollar cost averaging. However, dollar cost averaging inside the contract is frequently provided at no charge.

Although dollar cost averaging may usually be used to transfer funds from one variable subaccount to another, insurers do not normally permit the owner to transfer funds from the contract’s fixed account under the dollar cost averaging option.

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Interest Sweep

Although insurers do not normally allow dollar cost averaging transfers from a fixed account, the

contract owner may direct the insurer to periodically transfer any interest earned in the fixed

account to one or more variable subaccounts under the interest sweep option. Normally the contract owner will select the variable subaccounts into which he or she wants the interest swept and indicate the percentage to be transferred into each of the selected subaccounts. In most cases, a contract owner may have the interest sweep take place monthly, quarterly, semi-annually or annually.

It should be clear that the benefit of the interest sweep option is similar to the benefit of dollar cost averaging. In both cases, the contract owner takes a fairly fixed amount of funds—the interest credited to the fixed account or a selected amount to be transferred—and uses it to purchase units of the variable subaccounts. Just as in dollar cost averaging, the interest swept into the variable subaccounts will purchase fewer units when the value is higher and more when the value is lower. Because of that phenomenon, the average per-share cost is lower than the average per-share price in a fluctuating market; furthermore, the overall contract value is less likely to be significantly affected by large swings in market performance. Although the insurer usually requires a minimum value in the fixed account for it to implement the interest sweep option, there is usually no cost for it.

As we can see, variable annuity contracts offer owners several tools with which to manage the policy’s cash value during its accumulation phase. These tools include:

• Diversification _• Dollar cost averaging

• Asset allocation _• Interest sweep

• Automatic asset re-balancing Variable subaccount transfer

Variable Annuity Payout Phase

Identical to a fixed annuity, the variable annuity contract’s payout phase begins when either of the following occur:

• A single premium immediate annuity is purchased

or

• A single or periodic premium deferred annuity is annuitized at the annuity starting

date

Depending on the annuity settlement option selected by the contract owner, a variable annuity payout guarantees a periodic income payment to the annuitant at specific intervals for a specified period of time. As we noted earlier in our discussion of annuitization options, the income may be paid for life or for a lesser period.

Unlike the periodic payments under a fixed annuity, the amount of each variable annuity periodic payment is not guaranteed. Instead, variable payouts may fluctuate up and down based on actual investment experience. (Some variable annuities offer contract owners a choice of fixed periodic payments or variable periodic payments while others offer variable accumulation but only fixed payouts.)

Insurers are not uniform in the amount of control granted to annuitants after annuitization. While some insurers permit the annuitant to direct how the annuity value is invested and permit variable

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subaccount transfers during annuitization, others do not. In the case of those other insurers, the value of the annuity is usually invested by the insurer in a variable subaccount comprised principally of stocks.

At the annuity starting date, the accumulation units are converted to annuity units, and the amount of each payout received by the annuitant is based on the value of the annuity unit. After annuitization commences, the number of annuity units remains fixed; however, the value of each annuity unit varies based on the performance of the separate account. If the insurer offers a fixed payout, the value of each annuity unit in the case of a fixed payout remains level, and each periodic income payment would be the same.

Three steps are required to calculate the number of annuity units at the variable annuity’s annuity starting date. They are as follows:

Determine the current contract value by multiplying the total number of accumulation units by the value per unit

Determine the first monthly payment by multiplying the current contract value, in thousands, by the guaranteed annuity rate

Determine the number of annuity units by dividing the first monthly payment by the current annuity unit value

For example, suppose that Bill Jones purchased a single premium deferred variable annuity for which he paid $50,000 ten years ago. Bill is about to retire, and he and his wife have selected the joint and survivor life income option. Bill has 11,000 accumulation units in his annuity, and each accumulation unit is valued at $12. The guaranteed annuity rate stated in the contract for the payout Bill has selected is $8.10 per month for each $1,000 of cash value. The current value of an annuity unit is $5.44.

We can calculate the number of annuity units that will be used to determine each monthly periodic payment to Bill and his wife.

In step 1 we can determine the value of Bill’s variable annuity contract by multiplying his 11,000 accumulation units by the value of one accumulation unit. Since each accumulation unit has a value of $12, the total cash value is $132,000. (11,000 x $12 = $132,000)

In step 2, we can determine the amount of Bill’s first periodic payment by multiplying the value of the annuity contract in thousands by the monthly annuity rate per $1,000. The result is $1,069.20. ($132 x $8.10 = $1,069.20) In step 3, we determine the number of annuity units (that will not change) by dividing

the first monthly periodic payment by the value of one annuity unit. Since the first monthly periodic payment is $1,069.20 and the value of an annuity unit is $5.44, Bill has 196.54 annuity units. ($1,069.20 ÷ $5.44 = 196.54)

Bill Jones and his wife will receive the value of 196.54 annuity units as long as either lives. If the annuity unit value declines to $5 next month, they will receive $982.70 (196.54 units x $5). If it increases to $5.75 in the month after that, they will receive $1,130.11 (196.54 units x $5.75).

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Features and Benefits

There are various features of a variable annuity that provide substantial benefits for a contract owner. During the accumulation phase of the variable annuity, those features and benefits are: Variable Annuity Features mean Benefits for the Contract Owner

Control of premium allocation means The contract owner can select from a variety of

variable subaccounts in order to achieve a potentially high return consistent with the level of risk the owner is willing to assume

Tax-deferred growth means Tax on the deferred annuity earnings is deferred

until the funds are distributed, resulting in a potentially larger accumulation

Automatic reinvestment means All earnings are automatically reinvested,

compounding any tax-deferred growth

Flexibility means Deferred annuities can be purchased with a single

premium or through a series of flexible premiums. Funds can be re-allocated from one variable subaccount to another as needed

The features and corresponding owner benefits continue in the payout phase as shown below:

Variable Annuity Features mean Benefits for the Annuitant

Wide selection of payout arrangements means The payout can be tailored to meet the

annuitant's needs

Lifetime income means The annuitant can’t outlive his or her

income

Potential hedge against inflation means The annuitant’s income will tend to grow

as inflation reduces its purchasing power

Suitability

There is no single investment that is appropriate for every investor; the same is true of a variable annuity. Purchase of a variable annuity should be considered by individuals who are willing to assume:

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• The responsibility for determining how the annuity premiums will be allocated among the available investment alternatives

and

• Increased risk in return for potentially higher annuity gains

When recommending the purchase of a securities product, such as a variable annuity to a customer, NASD rules require that an agent or registered representative must have reasonable grounds to believe that the purchase is suitable for the customer. Those reasonable grounds must be based on the customer's:

• Age _• Financial situation

• Other securities holdings _• Needs

• Tax status _• Objectives

The amount of risk that the contract owner assumes usually depends on the variable subaccounts that he or she has selected. A variable annuity will usually offer a money market investment option that is very conservative and which offers a combination of high safety of principal and liquidity as the primary investment objective. Although such an investment option would offer smaller potential rewards than would other investment options, it may satisfy the contract owner’s need for safety of principal. In contrast, variable subaccounts that invest in stocks offer potentially greater rewards, but involve the risk of a loss of principal. (See the Appendix for a review of bond ratings and basic characteristics of securities.)

The contract owner is given the opportunity to balance risk and reward consistent with his or her risk tolerance and investment objectives by allocating the annuity premium among several variable subaccounts.

In addition to these general principles relating to the suitability requirement, the NASD has published two important Notices to Members that bear directly on variable annuity suitability. In Notice to Members 96-86, the NASD provides guidelines with respect to the specific factors that could be considered by the agent or registered representative under the NASD suitability rule when he or she is recommending that the customer purchase a variable product. Those factors include the customer’s:

• Life insurance needs

• Expressed preference for a non-insurance product

• Understanding of the variable product’s complexity

• Appreciation of the extent of variable product charges

• Need for liquidity and short-term investment

• Need for retirement income

and

• Investment sophistication & ability to monitor separate account performance

Regardless of whether the product being recommended is a variable annuity or variable life insurance, the customer’s life insurance needs should first be assessed. That life insurance need assessment will assist the registered representative in determining the suitability of variable life insurance, variable annuities or other, non-insurance product.

Sometimes a customer will state that he or she is not interested in an insurance product of any sort. Even if the customer is misinformed about the product, his or her expressed desire for a non-insurance product should be followed, despite a variable product’s being more appropriate to the customer’s particular situation and goals. (In such a case, appropriate file documentation should be done.)