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Annuity Products |
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Death Benefits in Annuity Contracts
One commonly overlooked aspect of annuities is the guaranteed death benefit they offer. As discussed above, when the contract is annuitized (i.e., changes from the accumulation phase to the annuity phase) the contractholder may select a number of different payout options — some which provide for continuing annuity payments to a designated beneficiary.
But what happens if the annuitant dies during the accumulation phase? All annuities provide for payment of the annuity's accumulated value to a beneficiary.
In fixed annuities, the amount payable to the beneficiary is simply the premium payments paid into the contract plus the interest credited to the contract, less any withdrawals the contractholder may have taken. In a fixed annuity, the beneficiary simply receives the "current value" of the contract.
In variable annuities, the basic death benefit is the greater of the owner's investment in the contract (less any withdrawals) or the current value of the sub-account(s). The basic death benefit of a variable annuity guarantees that a beneficiary will receive, at a minimum, the monies invested in the account — and could receive far more, if the sub-account values increased.. Some variable annuity contracts offer the investor the option of purchasing enhanced death.
The death benefit feature of an equity indexed annuity is less clear. Some contracts will provide beneficiaries with return of the full investment plus whatever interest has been credited to the contract to date; others will return the investment plus the minimum guaranteed rate (but not the higher index rate). Each EIC is different, so it is important to read the fine print carefully.
Most annuity contracts, in the event of death, will waive any surrender charges that may apply. It is important to note that in all annuities — fixed, indexed, or variable — the minimum death benefit is designed to simply conserve the initial investment for beneficiaries. In this way annuities do afford some protection for beneficiaries, but if the goal is to maximize the amount left to beneficiaries, life insurance, not annuities, offer the greatest protection.
Remember, the guaranteed minimum death benefits are payable only if death occurs during the accumulation phase. Once the contract is annuitized, payments will continue according to the method selected by the contractholder (which may or may not include eventual payments to a beneficiary, depending on the selected payout option.)
Annuity Fees
One of the strongest arguments against the use of annuities as an investment is that they are laden with fees and other charges. While it is true that there are numerous fees associated with annuities, annuities provide a bundle of benefits not readily available through other investments and those fees represent the annuity company's compensation for providing that package of benefits. Whether a client needs all of the features of a particular annuity contract offers, and whether the fees are adequately disclosed to prospects are key questions in determining the suitability of the contract for that client. That said, few agents understand the cost structure of the annuities they sell — and perhaps because of this, they fail to adequately disclose and explain those costs. Annuity companies could certainly provide more transparency in how they structure their costs, better training for their agents and more clearly written sales materials.
Fixed Annuity Cost Factors
The simplest annuity, in terms of fees or other charges, is the fixed, single premium, immediate annuity (fixed SPIA). This represents a lump sum deposit with the annuity company, which invests those funds in the company's general assets. Periodic income payments to the annuitant begin immediately. Fixed SPIAs generally have no front-end sales charge or annual contract charges. Since these contracts are annuitized immediately, these contracts generally offer no control or flexibility to the contractholder. The annuitant can simply expect to receive his or her monthly income payment for the rest of his or her life. Some contracts, however, may permit commutation or partial withdrawals, and the annuity company will charge a fee for those distributions. The only cost component in an SPIA is built into the annuity payout factors.
Immediate Annuity Payout Factors
Each company will develop a schedule of annuity payout factors. These factors represent the monthly income payments that an annuitant will be paid if the account is annuitized. Annuity payout factors are based on the type of payout method selected by the contractholder, the current age of the income recipient, the recipient's gender, the company's assumptions on future interest rates and its projected expenses (including a profit for the company).
All contractholders who annuitize will pay an indirect profit component that is built into the annuity payout factors. Immediate annuities are immediately annuitized, so holders of immediate annuities will always pay this cost. Deferred annuity holders who elect to annuitize their contracts will also pay this cost.
The company's assumptions and projections are subject to change, so the annuity payout factors offered by companies will change over time, too. But once the contractholder decides to annuitize the current factors at that time are locked in, and that factor will be used for all future annuity payments. All future payments will be based only on that factor. In the case of immediate fixed annuities, the annuity payments will be fixed at the contract's inception. Those payments will never change, unless the contract contains a cost of living adjustment (which most do not).
Deferred Fixed Annuities
Deferred fixed annuities (whether funded by a single, lump-sum premium or flexible premiums over time) have far more complex cost structures. Historically, fixed deferred annuities imposed fewer and simpler charges than their variable cousins, but the trend is toward more complexity in both. Purchasers of fixed deferred annuities may pay any or all of the following costs (depending on the contract):
Front-end sales charge. Until recently an up-front sales charge (or "load") was commonly included in a fixed deferred contract. These are very unpopular with consumers; so few contracts today assess this charge. The load is generally stated as a percentage of the initial or subsequent premiums. In many cases it is expressed on a sliding scale — the larger the premium, the smaller the percentage.
Surrender charges. As the name implies, this charge applies if the contract is surrendered, but may also apply if the contractholder makes a substantial partial withdrawal. Most fixed deferred annuities allow withdrawals up to 10% of the contract balance each year without penalty, any excess withdrawal is subject to the charge. Each contract will spell out how the penalty is applied to excess withdrawals (is the 10% applied to each year separately or can unused withdrawals from one year be "rolled over" into future years?) but the 10% penalty-free figure is fairly standard industry wide. The surrender charge is usually a expressed as in a declining schedule: for example 5% if surrender in the first year, 4% in the second year, 3% in the third year, until the surrender charge reaches zero in year 6. In the case of flexible premiums, the clock may start ticking based on contract’s date or the contract may call for surrender charges on a rolling basis, with the new timeframes applied for each additional premium paid to the company. Most contracts will waive surrender charges upon the death of the annuitant (or contractholder). Likewise, many contracts will waive the charge if the owner is confined to a nursing home, becomes disabled, or suffers from a "dread disease" listed in the contract's terms.
These two charges (sales charge or surrender charge) allow the company to recover its "acquisition costs" — the cost to put the contract in force. One of those acquisition costs, but by no means the only one, is a commission paid to the salesperson. Almost all fixed annuities are sold by commissionable agents and the company must recover that cost, as well as the cost to develop the product, administrative costs, and a profit. If the contract is kept in force long enough, the company will eventually recover the acquisition costs and make a profit from various aspects of the contract. But if the contract is terminated in the early years the company loses those costs and the opportunity for profit. Hence the surrender charge (or its predecessor, the sales charge).
Contract charges. A few deferred annuity contracts assess an annual charge. If the company does impose a contract charge it will generally waive the fee when the account balance exceeds a certain amount (e.g. no contract charge if the account balance exceeds $50,000). In effect, this is a fixed dollar fee per contract to cover administrative expenses of small, less profitable contracts.
Market Value Adjustment. Fixed annuities are typically backed by fixed-income investments such as bonds held in the company's general assets. If interest rates increase after the contract is issued, contractholders may choose to surrender the contract and to take advantage of other higher-yielding investments. Unfortunately for the company, if interest rates increase, the value of their fixed-income investments will decrease — and the company may have to sell investments at a loss to pay off the surrendered contracts. The market value adjustment addresses this situation. It states that if interest rates (based on some benchmark index) are higher at the time of surrender, the surrender value will be decreased; and vice versa if interest rates have declined. Generally speaking, the market value adjustment applies only on withdrawals in excess of the penalty-free amount, and only during the surrender charge period.
Interest rate spread. The interest rate spread, also called the yield spread, is typically the contract's greatest source of profit for the company. The spread represents the difference between what is promised to the contractholder and what the company can earn from its investments. This is also one of the most shadowy costs to the contractholder. The company will disclose what rate of interest it is will pay on the contract, but the rate of return the company earns on its investments is not disclosed (at least not directly to the contractholder).
Equity Indexed Annuity Costs
Equity Indexed Annuities are a form of fixed annuity. What sets them apart is that the rate of return is tied to the performance of a stock index as opposed to a renewal rate set at the annuity company's discretion. Unlike variable annuities with their separate subaccounts, equity indexed contracts are backed with equity indexed stock options held in the company's general account. To cover the cost of those options, the company imposes participation rates or yield spreads. Remember that traditional fixed annuities rely on interest rate spreads — the difference between what the company promises the contractholder and the rate the company earns on its investments — to generate a profit for the company. The participation rates, yield spreads and caps perform the same function in an EIC — creating a difference between what is promised to the contractholder and what the company earns. In the case of EIC, the company earns the full return of the index; the "moving parts" of the EIC serve to reduce the return promised to contractholders, and thus generate a profit for the company. The interest rate spread was the most shadowy cost of a fixed annuity. EICs by contrast disclose the costs imposed by the moving parts openly, although it is rarely explained to prospects as a "cost". Perhaps this is because most agents are just as confused by the complexity of an EIC’s interconnected "moving parts" as clients are.
Like other fixed deferred annuities, EIAs may impose many of the same charges. Most EIAs do not impose a front-end sales charge, but rely instead on surrender charges. Surrender charges are central to many complaints of EIAs and advisors must carefully consider how surrender charges affect the suitability of EIAs for each client's unique situation.
Variable Annuity Cost Factors
Variable annuities, in effect, represent an investment vehicle wrapped within an annuity contract. Variable annuity contract have a number of costs, some relate to the subaccount's investments, others apply at the contract ("wrapper") level. Florida’s Senior Suitability Law carves out an exemption for agents selling variable annuities, choosing to defer to federal rules (FINRA) on the suitability of sales of variable contracts to senior consumers. A discussion of variable annuities and other equity investments is beyond the scope of this course. For agents seeking a detailed discussion of variable annuities fees, please click here.
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