Annuities

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Annuities
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What are Annuity Contracts?

• Causes a regular stream of payments to an
  annuitant
• Usually contingent upon survival
• Used mostly for retirement income
• Requires a reduction in current consumption
• Can reallocate consumption from employment years
  to retirement period
• tax deferred basis
• penalty if withdrawn before age 59 1/2
• Can be used to guarantee income streams so other
  property may be gifted bequests can be made

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How Life Income Annuities Work

• Uses pooling process based upon mortality tables
  Survivorship tables are not the inverse of
  mortality tables
• Individuals who die early provide survivor
  benefit
• Can provide more income than interest liquidation
  only
• No medical exams required
• Amount paid is a function of
• amount accumulated
• age and sex upon distribution
• type of annuity chosen
• Origination of Annuities Tontines

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How Annuities are Acquired - 1

• Pension Benefits
• Small employers (lt50) use annuities on a
  contributory or a non-contributory basis
• on both tax advantaged and non-advantaged basis
• Individual Purchases
• people who buy annuities generally live longer
• advantage to earlier and greater initial funding
• tax advantages
• professional management of funds

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Funding Examples Early Accumulation Avg. vs.
Geometric Rates
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How Annuities are Acquired - 2

• Life Insurance Conversions
• Change cash value life insurance to a settlement
  option when death benefits no longer needed
• Since annuities include a survivor benefit -
  benefits can be greater than comparable risk
  investments paying dividends and/or interest

Needs reduce so convert to an annuity- use
settlement options
Cash Value
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How Annuities are Acquired - 3

• Private Annuities
• Series of payments made by a person in exchange
  for value
• PV annuity equal to to the fair market value
  otherwise taxable gift may occur
• example father sells house/farm to family member
  in return for life income annuity
• An Insured private annuity life insurance is used
  to guarantee annuity payments

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Life Income Annuity Accumulation and Distribution
Phase
Accumulation period
Distribution period
Contract inception
Date of annuitization
Benefits terminate
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Annuities can be classified by

• Premium Payments and the timing of receipts
• Benefit Calculations
• Rent - Fixed vs. Variable

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Premium Payments and timing of receipts - 1

• Immediate Annuity
• Single Deposit and benefits start on the next
  payment date
• Single Premium Deferred Annuity
• Single Deposit but annuitant must wait for
  benefits to start at least one payment date
• minimum guaranteed rate
• interest tax deferred upon liquidation interest
  only is taxable
• 1035 tax free exchange possible to another
  carrier but surrender charges may apply
• expense loads maybe rear-end, front-end, both
  rear-end usually phased out over time

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Premium Payments and timing of receipts - 2

• Flexible Premium Deferred Annuity
• Same as SPDA but
• premium flexible
• lower minimum amount
• loads arranged differently
• operating expenses higher

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Premium Payments and timing of receipts
Dollars
Accumulation phase
Liquidation phase
Age ?
?
?
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Benefit Calculations - 1

• Premium Amount
• Accumulated amount at time of annuity calculation
• Age Upon Liquidation
• older
• accumulated amount more
• fewer expected payments
• higher benefits
• Once started rate or amount typically remains
  constant

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Benefit Calculations - 2

• Sex
• Women live longer than men therefore lower rent
  paid
• separate tables - sex based
• set back approach use male table but set back
  number of years i.e. 5
• Civil Rights Act of 1964 bans sex based
  collections and benefits
• U.S. Supreme Court eliminated sex based tables
  for private pension plans but can be legally used
  for individual purchases (sex-distinct)

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Benefit Calculations - 3

• Number of Lives
• One life - individual annuities
• two lives - joint annuities
• joint life annuity - both must be alive
• joint and last survivor annuity - annuity paid to
  both then to survivor until survivor dies
• joint and 1/2 (2/3, 75) survivor annuity - 100
  annuity paid to both then 1/2 to survivor -
  starts off higher than joint and survivor

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Benefit Calculations - 4

• Minimum Guarantees
• Pure life annuity, straight life annuity, life
  income annuity - no guarantees
• Annuity certain - no life contingencies - pays to
  annuitant or beneficiary(ies) until funds
  distributed
• Temporary life annuity - ends at the expiration
  of time or death, whichever comes first
• Period certain life income annuity - minimum
  number of years or life, whichever is longer
• Refund annuity - cash or installment refund -
  pays until at least the premium is distributed or
  for life if longer

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Benefit Calculations - 5

• Participating contracts
• excess interest paid during accumulation and
  distribution process
• accumulation - increases surrender value
• distribution - adjustment of annuity rates when
  converted to distribution period

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Rent - Fixed vs. Variable

• Fixed - benefits remain unchanged
• Variable - attempts to maintain a level
  purchasing power through underlying investments
• Mechanics of variable annuities
• Deferral period - invest in various annuities
• Distribution period
• calculate fixed benefit annuity
• How many units needed to pay fixed benefit
• number of units liquidated does not change but
  value of each unit changes based upon underlying
  portfolio

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Taxation of Annuities

• If Contributions on a before-tax basis.
• All Distributions are included in taxable income.
  
• 10 penalty for premature distributions before 59
  1/2
• Does not apply if annuitized

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Taxation of Annuities

• If contributions are on an after-tax basis
  (normal for individual annuities)
• Exclusion Ratio Applies

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Taxation of Annuities - Exclusion Ratio

• EXAMPLE
• PREMIUM 50,000
• IRS MULTIPLIER 20 YEARS
• ANNUITY PER YEAR 6,000
• Exclusion Ratio 50,000 / (20 X 6,000) 0.4166
  excluded from taxable income
• 1 - 0.4166 0.5833 included in taxable income
• 6,000 X 0.5833 Included in taxable income
  3,500
• 6,000 X 0.4166 return of principle of each
  payment 2,500.
• After 20 years, lose benefit of exclusion ratio.

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Life Insurance Enhancements

• Variable accumulation benefits can be less than
  the amounts contributed because of market
  fluctuations.
• Standard Benefit the accumulation value at the
  time of death.
• Annual Ratchet pays the greater of the standard
  benefit or the highest value of the account on
  any prior anniversary (average cost 25 basis
  points or 25 hundredths of 1 percent)
• Percentage Enhanced Benefit pays the greater of
  the standard benefit or total payments plus a
  stated percentage compounding varies and may
  stop at some point. (average cost 35 basis
  points)
• Combined Enhancement pays the greatest outcome
  of the 3 above methods (average cost 45 basis
  points)

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Recent Developments in Variable Annuity Guarantees

• Guaranteed Minimum Death Benefit (GMDB)
• Guaranteed Minimum Income Benefit (GMIB)
• Guaranteed Minimum Accumulation Benefit (GMAB)
• Guaranteed Minimum Withdrawal Benefit (GMWB)
• Cost of each can be 15 to 75 basis points of
  premium paid. (basis point 1 hundredth of 1
  percent)

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Guaranteed Minimum Death Benefit (GMDB)

• No GMDB value of fund would be paid.
• With GMDB provides a guaranteed amount by
  formula.
• Example 100,000 premium paid, Value 75,000
• Death occurs then 100,000 paid to beneficiary. If
  value over 100,000, that value would be paid.
• If formula deposits plus interest, than the
  higher amount would be paid.

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Guaranteed Minimum Income Benefit (GMIB)

• No GMIB, liquidation income stream set by account
  value and mortality table factors.
• With GMIB, interest and mortality factors
  guaranteed at the date of issue.
• Account value declines or mortality factors less
  favorable, the GMIB is paid.
• Example 150,000 deposits but value drops due to
  adverse stock market and is worth 75,000.
• GMIB liquidation payments will be based on
  150,000. If larger, based on the larger amount.
• Some insurers also provide minimum interest
  guarantee so the 150,000 minimum would increase.

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Guaranteed Minimum Accumulation Benefit (GMAB)

• No GMAB if surrender the contract get current
  value of contract.
• With GMAB entitled to guaranteed minimum value
  to premium paid. Some insurers guarantee a
  minimum interest.
• Example deposits 100,000, end the annuity and
  actual accumulation 80,000.
• GMAB is able to withdraw 100,000
• Some provide ratchet provision. If at 10 years
  accumulation worth 200,000, minimum is reset to
  200,000.

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Guaranteed Minimum Withdrawal Benefit (GMWB)

• No GMWB Some percentage may be withdrawn each
  year (eg 6) of the account value. If bad year
  the based on a percent will decline.
• With GMWB Sets max withdrawal of premium
  paid. Or if value higher of that amount.
• Example 150,000 annuity premiums with a 6
  withdraw rate. If value 150,000, 6 9,000. If
  value 100,000, 6 6,000
• But if GMWB withdraw rate based on 6 of 150,000