Chapter 2 — Annuity Products

• Every annuity has two distinct phases: the accumulation period (premiums paid in, interest credited) and the annuity period (periodic income payments paid out)
• Fixed annuities credit a declared interest rate to the company’s general account; the insurer bears all investment risk
• Variable annuities credit returns based on separate account performance; the contractholder bears all investment risk
• Equity indexed annuities (EIAs) are a form of fixed annuity that guarantee principal while crediting interest tied to a stock index (typically the S&P 500)
• Fixed annuities use four interest crediting methods: Portfolio, New Money, Sliding Scale, and Tiered Rate
• EIA “moving parts” — participation rates, yield spreads, and caps — limit the amount of index gain credited to the contract
• All annuities provide a minimum death benefit during the accumulation phase; the basic benefit in variable annuities is the greater of the investment or current account value
• Florida’s Safeguard Our Seniors Act limits surrender charges on senior annuities to 10% maximum over no more than 10 years
• Annuity earnings grow tax-deferred; all growth is taxed as ordinary income (never capital gains) when distributed
• Group annuities sold to employers for qualified retirement plans are exempt from Florida’s Senior Suitability Law

An annuity is simply a vehicle for liquidating a sum of money over time. Start with a lump sum, pay it out in equal installments over a period of time until the fund is exhausted — and you have created an annuity. The sum not yet paid out earns interest, which eventually passes to the recipient. Individuals may fund annuities with a single premium or through periodic payments over time.

Every annuity has two distinct time periods:

• Accumulation period: The contractholder pays premiums; the insurer credits interest. During this phase the contractholder retains control — he or she may withdraw funds, surrender the contract, or exchange it for another annuity. The accumulation period can last years, or may be momentary (as in an immediate annuity).
• Annuity period: The insurer pays periodic income to the recipient. The conversion from accumulation to annuity is called annuitization. Once annuitized, the contractholder loses control over the account. Payments are typically monthly, though quarterly, semiannual, or annual options are available.

The amount of each annuity payment depends on three factors: accumulated principal, interest rate, and payment period. Life insurance companies uniquely add a fourth factor — the survivorship factor — enabling them to guarantee lifetime payments. Some contracts have no required annuitization date; others impose a maturity date by which annuitization must begin.

Fixed annuities provide a guaranteed minimum rate of return. Contractholder premiums are placed in the insurer’s general account, which invests in conservative, long-term securities (typically bonds). The insurer credits a steady interest rate to the contract — a current (declared) rate that cannot be less than the contract’s minimum guaranteed rate.

Interest Crediting Methods

Four basic methods are used to apply the current interest rate:

• Portfolio Method: All contracts are credited the same declared rate regardless of when premiums were paid — the simplest and most straightforward approach.
• New Money Method (“pocket of money”): Different rates apply to contributions made in different years based on when the premium was paid. A contract may carry multiple rates simultaneously.
• Sliding Scale Method: Higher balances earn higher rates. For example: 4.25% on the first $50,000; 4.50% on the next $50,000; 4.60% above $100,000.
• Tiered Interest Rate Method: Two values are maintained — a higher annuity value (used if the contract is annuitized) and a lower cash value (used if surrendered). This incentivizes annuitization over surrender.

Rate Renewal & Special Features

• Bail-out rate: If the renewal rate drops below a stated bail-out rate, surrender charges are waived, allowing the contractholder to move to higher-yielding investments penalty-free.
• CD Annuity: Guarantees the initial rate throughout the surrender charge period (typically 6 years). Designed as a tax-deferred alternative to bank CDs.
• Bonus interest: An extra rate credited above the renewal rate for the first year or two. Attractive in marketing, but may come with higher surrender charges or lower guarantees.

Variable annuities shift the investment risk from the insurer to the contractholder. Instead of the general account, premiums are credited to a separate account (also called a sub-account) invested in securities the contractholder selects. This creates the potential for returns exceeding a fixed annuity in bull markets — but also the risk of declining values in bear markets.

Accumulation Units

During the accumulation period, contributions purchase accumulation units in the selected separate account. The value of each unit is calculated daily by dividing the total separate account value by total units outstanding. As the underlying portfolio rises and falls, unit values follow.

Annuity Units

At annuitization, accumulation units convert to annuity units. The number of annuity units remains fixed for the annuitant’s lifetime; however, the value of each unit changes monthly based on investment results relative to the contract’s Assumed Interest Rate (AIR):

• If investment returns equal the AIR — annuity unit value is unchanged
• If investment returns exceed the AIR — annuity unit value increases; payments grow
• If investment returns fall short of the AIR — annuity unit value decreases; payments shrink

Equity indexed annuities (EIAs/EICs) are a form of fixed annuity that offer higher potential returns than traditional fixed annuities while guaranteeing the owner’s principal. Interest credited is tied to gains in a specific equity index (most commonly the S&P 500). A minimum guaranteed rate (typically 3–4%) applies if the index underperforms. At the end of the contract term (usually 5–10 years), the contract credits the greater of the guaranteed minimum value or the indexed value.

Indexing Methods

• Point-to-Point: Measures the total change between the index value at contract inception and at the end of the term. Simple to understand; the investor doesn’t know the final rate until the term ends.
• Annual Reset (Ratchet): Credits gains year by year; losses in any year are ignored (treated as zero). Gains can accumulate even if the index is below its starting value. Provides downside protection at the cost of potentially lower overall returns.
• High Water Mark: A variation of point-to-point that uses the highest index value recorded on specified dates during the term, protecting against declines in the final years.
• Averaging: Uses average index values over a period rather than a single date, smoothing out extreme highs and lows.

The “Moving Parts”

EIAs limit the amount of index gain credited through several mechanisms that interact with each other:

• Participation rate: The percentage of index gain credited. An 80% participation rate on a 15% index gain credits only 12% to the contract.
• Yield spread: A fixed annual amount subtracted from the indexed return. A 3% yield spread on a 10% index gain results in 7% credited.
• Cap: A maximum gain that can be credited regardless of index performance. An index cap of 12% limits the gain regardless of how much higher the index may have risen.

All annuities provide payment of the contract’s accumulated value to a named beneficiary if the annuitant dies during the accumulation phase:

• Fixed annuities: The beneficiary receives the contract’s current value — premiums paid plus credited interest, less any withdrawals.
• Variable annuities: The basic death benefit is the greater of the owner’s total investment (less withdrawals) or the current sub-account value. This guarantees that beneficiaries will receive at least what was invested, even in a down market.
• Equity indexed annuities: Death benefits vary by contract — some return the full investment plus credited interest; others return the investment plus only the minimum guaranteed rate. Read the contract carefully.

Most contracts waive surrender charges upon the annuitant’s death. Once a contract is annuitized, death benefits depend on the payout option selected and may or may not include continuing payments to a beneficiary.

Few agents fully understand the cost structure of the annuities they sell — and as a result, they fail to adequately disclose and explain those costs to clients. Whether a client needs all the features of a particular contract and whether fees are adequately disclosed are key questions in any suitability determination.

Fixed Immediate Annuity (SPIA)

The simplest annuity in terms of fees. Fixed SPIAs generally have no front-end sales charge or annual contract charges. The only cost is built into the annuity payout factors — a profit component embedded in the periodic payment calculation.

Deferred Fixed Annuity Charges

• Front-end sales charge (load): Uncommon today; stated as a percentage of premium, often on a sliding scale.
• Surrender charges: Apply if the contract is surrendered or if withdrawals exceed the penalty-free amount (typically 10% of contract balance per year). Usually expressed on a declining schedule (e.g., 5%, 4%, 3%, 2%, 1%, 0% over 6 years). Most contracts waive surrender charges on death, nursing home confinement, disability, or dread disease. Florida’s Safeguard Our Seniors Act limits surrender charges on senior annuities to 10% maximum over no more than 10 years.
• Contract charges: Some contracts impose a small annual fee, typically waived when the account balance exceeds a threshold (e.g., $50,000).
• Market Value Adjustment (MVA): If interest rates rise after the contract is issued, the surrender value may be reduced; if rates have declined, the surrender value may be increased. Applies only to excess withdrawals during the surrender charge period.
• Interest rate spread: The difference between the rate the company credits to the contract and the rate the company earns on its investments — the insurer’s primary profit source, and the least transparent cost.

Equity Indexed Annuity Costs

EIAs use participation rates, yield spreads, and caps to cover the cost of the indexed equity options that support the contract. While these “moving parts” are disclosed in the contract, they are rarely explained to prospects as costs. Surrender charges are particularly important for EIAs and must be carefully evaluated for suitability with each senior client.

Annuities offer tax-deferred growth — a significant advantage. However, the tax code governing annuities is complex and contains traps for the unwary. Advisors must be aware of the regulations and refer clients to a tax advisor when appropriate. The following summarizes the tax treatment of non-qualified annuities held by individual taxpayers:

During the Contractholder’s Lifetime

• All earnings in the account grow tax-deferred. (Note: corporations and some trusts do not enjoy tax-deferred growth.)
• When distributed, all growth is taxed as ordinary income — never as capital gains, regardless of whether it comes from interest (fixed) or stock market gains (variable).
• If the contract is annuitized, each payment is part return of principal (tax-free, based on an exclusion ratio) and part return of earnings (taxable).
• Surrender: All value in excess of the contractholder’s cost basis is fully taxable as ordinary income.
• Partial withdrawal: For contracts purchased after August 12, 1982, withdrawals are treated as earnings first (LIFO) — fully taxable until all gain is withdrawn; then tax-free return of principal. Pre-August 12, 1982 contracts use FIFO (principal first, then earnings).
• 1035 Exchange: Under IRC Section 1035, a contractholder may exchange one annuity for another with no immediate tax consequences. Life insurance may be exchanged for an annuity tax-free; annuities may not be exchanged for life insurance.

Upon the Contractholder’s Death

• Beneficiaries receive the cost basis tax-free (FIFO); all gains are taxable as ordinary income.
• Unlike life insurance death benefits, annuity death benefits are not income tax-free to beneficiaries.
• As a general rule, beneficiaries must take the accumulated value from the account no later than 5 years after the date of death (with some exceptions).
• For estate tax purposes, the full value of the contract (or remaining payments) must be included in the decedent’s estate.

Corporations use group annuities primarily to fund and distribute pension payments to retirees. Group annuities allow corporations to shift investment and mortality risk to insurance companies — enabling the expansion of retirement benefits to rank-and-file employees.

Qualified Plans

When ERISA reorganized federal pension laws in 1974, traditional pension plans were reclassified as defined benefit plans (fixed benefit formula). ERISA imposed accounting and funding requirements, but plans that purchase an annuity to guarantee funding are exempted from many additional costs — motivating many plans to become annuity purchase plans.

Over time, many companies shifted to defined contribution plans (the employer guarantees a fixed contribution, not a fixed benefit). 401(k) plans and Tax Sheltered Annuities (TSAs for non-profits) are common examples. Defined contribution plans shift investment risk from employer to employee.

In general: contributions to qualified annuities are tax-deductible; earnings grow tax-deferred; and payouts to retirees are fully taxable as ordinary income in the year received. A 1982 ERISA amendment requires retirement benefits for married workers to be paid as a joint annuity unless the spouse waives this requirement in writing.

Non-Qualified Plans

Corporations may also use annuities to fund non-qualified deferred compensation plans for key employees. These plans are not subject to ERISA’s strict rules. The employee defers current taxable compensation in exchange for greater future retirement benefits — ideally received in a lower tax bracket.