ANNUITIES
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The tax code allows tax sheltered vehicles called annuities to be used by both individuals and corporations to provide benefits primarily to those people who are 59 or older. They are products of the insurance industry and represent a contract between the individual (annuitant) and an insurance company. Annuities are for those people concerned about payments while they are still alive rather than the focus of insurance wher either form, the individual pays the insurance company a set amount of money during the accumulation stage (when putting money in) either as a lump sum (single premium deferred annuity) or on an annual or monthly ich is to pay a benefit to beneficiaries when they die. An annuity therefore provides a means by which invested capital can be distributed over a lifetime- or one of many other options.
The annuities take basically two forms- fixed and variable- although there
may be the odd company that offers a combination of the two. Undpayment (periodic
payment or flexible premium deferred annuity). Most annuities are paid for
with after tax dollars- that is, money which has been received by the individual
and on which taxes must be paid. The main advantage to putting the funds
into an annuity is that any interest on the invested funds are able to grow
tax deferred until such time as the money is withdrawn (annuitization stage)
.
FIXED ANNUITY
The annuity company normally markets an interest rate that they will "guarantee"
during the accumulation stage for one year or for as long as five years.
Additionally, they also guarantee a minimum floor rate which means that
irrespective of how low rates may go in the economy, they will pay at least
that amount. (That amount has dropped during the last five years as interest
rates overall have decreased.) With the fixed annuity, you are guaranteed
that whatever rate has been identified, it is "guaranteed" to be paid by
that annuity/insurance company out of their general account. The annuitant
takes no risk- except that of the company remaining financially strong. Problems
have happened in the industry however, when the insurance companies utilized
more aggressive investments in their general account- primarily high yield
bonds. Baldwin United, First Capitol and Executive Life are the major companies
that have defaulted on payments. The guarantee is therefore NOT the same
as the government FDIC.
The company pays for expenses (including commissions) and mortality costs
out of the total return on the investments in the general account. They also
have to leave a "spread" for profit. Flexibility exists for companies to
revise their rates each year as conditions change- as identified with changes
in the returns during the accumulation stage. However, adjustments are not
allowed during the annuitization stage. This fixed return remains constant
for the 10, 20 or 30 years of possible payments. This means that if expenses
should skyrocket or if many more people live longer- both of which will
considerably reduce the company's earnings- the changes (supposedly) will
have no impact on the security of your principal or the continued payment
of your money. Both theoretically and practically, this should be true. With
a highly rated company (A or A+), company actuaries have already accounted
for any possible adjustments in mortality and annuitants should not expect
problems. With lower rated companies, the considerations for use either during
the accumulation stage or the annuitization stage requires the realization
of risk of default. Admittedly, most states have guarantee funds, but this
should not be relied upon as returning all funds.
A.M. BEST RATING: Probably one of the most important items for a consumer to be concerned with is the independent rating by A.M. Best Company. As with insurance offerings, the company selected should have at least an A or A+ Best rating. The corresponding ratings from other major services are also shown.
Rank Ratings
| Rating | AM Best | S&P | Moody's | Weiss | Duff & Phleps |
| Superior | A++ | AAA | Aaa | A+ | AAA |
| A+ | |||||
| Excellent | A | AA+ | Aa1 | A | AA+ |
| A- | AA | Aa2 | A- | AA | |
| AA- | Aa3 | B+ | AA- | ||
| Very Good | B++ | A+ | A1 | B | A+ |
| B | A | A2 | B- | A | |
| A- | A3 | C+ | A- | ||
| Good | B | BBB+ | Baa1 | C | BBB+ |
| B- | BBB | Baa2 | C- | BBB | |
| BBB- | Baa3 | D+ | BBB- | ||
| Fair | C++ | BB+ | Ba1 | D | BB+ |
| C+ | BB | Ba2 | D- | BB | |
| BB- | Ba3 | E+ | BB- | ||
| Marginal | C | B+ | B1 | E | B+ |
| C- | B | B2 | E- | B | |
| B- | B3 | - | B- | ||
| Below Standards | D | CCC | Caa | F | CCC+ |
| E* | CC | Ca | - | CCC | |
| F** | C,D | C | - | CCC- |
* Under state supervision
** In Liquidation
As a cautionary note, be aware that some "lesser" rated insurance companies
are using unknown rating services. In such cases, they are showing A+ ratings-
but they represent the LOWEST rating in that particular services guide.
Misrepresentation??
A.M. Best met with considerable criticism several years ago with the demise of Executive Life in that it supposedly did not recognize the risk of the high yield bonds fast enough- or at all. However neither did S&P, though others had downgraded it faster.
As regards my current philosophy and teachings, I usually suggest that an
agent/consumer use the rankings of at least A- from AM Best, AA- from S&P,
Aa3 from Moody's and AA- from Duff and Phelps. Remember also that they do
not use the same criteria in ratings so if a company has more than one rating
service, just mix and match. In other words, an Aa2 from Moody's and a A+
from AM Best would appear to be pretty good. Weiss's ratings have gotten
a lot of press, but he is not an actuary and therefore relying solely on
this rating is not advisable.
STATE INSURANCE: While it is rare that companies default, particularly those with very high ratings, it is possible. In such cases, your state insurance guarantee fund may help. However, (1992) there are a few states such as Alabama, Colorado, New Jersey, Louisiana and Wyoming that do NOT have reserves to pay off health and life insurance holders if a company goes bankrupt. California has instituted a life insurance guarantee fund. Effective 1/1/91, coverage will be provided for 80% of the contractual obligations of a failed company up to a limit of $100,000 on annuities and $250,000 on life insurance death benefits. Maximum coverage for any one individual is $250,000. There is a $5 million aggregate cap on group contracts. Additional restrictions include the following:
No coverage allowed if the insured is
1.eligible for coverage from another state,
2. the insured is not authorized to do business in the state,
3.and the policy was issued by a charitable organization, fraternal benefit society, and a few other entities.
There is also no coverage for a contract where
1. the insured assumes the risk- such as a variable contract,
2. any policy of reinsurance,
3. for interest rates that exceed an average rate,
4. dividends,
5. unallocated annuity contracts or a program that is self funded or uninsured.
Obviously, different states have different limits, but the most noted issue is that you may not receive any benefits if a policy is purchased out of your residence state. For example, should you visit California from your home state of Kansas, and subsequently buy a policy in California, the move back to Kansas could negate any insurance if the company went under. California insurance covers California residents. Kansas covers insurance policies approved and purchased in Kansas. There may be reciprocity rules that allow some coverage. But you would need to check BEFORE a policy was purchased. Additionally, the agent most often has to be licensed in BOTH states.
INTEREST RATES: Annuity companies offer a wide variety of interest rates to induce people to invest money with a company. They first guarantee floor rates- meaning that during the contract time, the interest rate offered by the company will never be lower than these floor rates. In past years the floor was typically 4.5% to 6%. Rates now are more apt to be 3% to 4.5% and reflect the changing economic environment. Obviously, however, if the company offered these low rates initially, no one would invest. Therefore literally all companies offer competitive rates guaranteed for at least one year- say 6.5%. Once the year is completed, the company has several options for consideration.
A company that uses an investment technique called old money, new money, may take all the funds after one year and put it in a "pot" with all the other funds it has collected throughout the years. There are several variations of this "pot" and are known as weighted average, portfolio and modified portfolio rate. Because of economics in the bond marketplace during the last few years, this old pot tends to have a lower interest rate than that which the company is offering new investors. Unless you are very familiar with the formulas used, it is very difficult to determine what final return could be forthcoming.
CAUTION: Some annuities are being advertised as "CD" annuities implying the same safety of FDIC available at a bank. This is false- they are only backed by the financial stability of the insurance company itself. Some states have already outlawed the use for the term "CD" in any of the advertisements. They do have the feature of tax deferral since none of the interest is taxed until withdrawn, but there are fees and penalties involved with early withdrawal so they are not for the ill informed.
Most annuities also have guarantees for longer periods of time and the rates reflect the underlying portfolio of securities held by the insurance company, the history of earnings, how they anticipate the economy growing or not growing, how actively they are seeking business and a host of other concerns. In context with the above paragraph on bank CD's, recognize that they invariably provide lower returns than independent annuities.
In any case, with the vast number of A and A+ companies actively seeking business, it pays to shop around. Although a .25% difference is relatively small and perhaps the greatest spread that might be anticipated currently, it would mean the difference of $250 on the first year of an $100,000 investment. Compounded annually over five years and the difference is $1,708- certainly worth a few phone calls.
SURRENDER CHARGES: Companies do not want to lose your money once it has been invested. And justifiably so since they have put that money to work for a long period of time, in most cases. Therefore they will penalize an investor for 5 to 20 years (sometimes indefinitely) if they try to take out any of their money prior to the time established by the contract. Few companies now take front end loads. Unless there is some mitigating reason, don't use companies with front end loads. Most companies favor back end loads called surrender charges. An example of a 10 year charge would be reducing percentages of 7,7,7,6,5,4,3,2,1,0. Some have continual charges such a 6% for all years or a loss of the last six months of interest. Or rolling surrender charges that are based on when you put each investment in. Most policies usually will allow an investor a 10% access to principal and interest after the first year with no penalty- withdrawals above that may be subject to as high as a 20% penalty. Some annuities are no load or low load and may not apply a surrender charge- though they seem most notable with variable accounts.
OTHER CHARGES: Some fixed annuity companies charge annual maintenance fees in addition to back end and possible front end loads. Front end and annual fees (normal of variable accounts) are usually indications of a company that is not competitive.
BAILOUT OPTION: As an additional inducement to entice clients to do business with a particular company and reduce the client concern about a low interest rate in the second and subsequent years, companies have been offering a bailout rate "guarantee". The company states that if the interest offered at the beginning of the second year is LESS than (or 1% less than) that offered in the first year, the client has the right to take the money out with no surrender charges. But it is more an empty guarantee with most companies. If a company has to drop its interest rate, it almost always means that all other companies are doing the same because of the drop in all investments yields. Therefore, even if the funds were transferred to another company, the rates would supposedly be no better than offered at the existing company. However, if you were using a "brand name" company (the bigger companies doing extensive amounts of advertising and marketing), their rates can almost always be bettered by independent agents reviewing independent annuity companies. But many of these companies simply feel you wouldn't make a switch for a 1/4 percent difference- and they are probably right.
VARIABLE ANNUITIES
Variable annuities require an agent to have not only a life insurance license, but a variable license and a security license as well. The security license, either a series 6 or series 7, allows an agent to sell mutual funds. A variable annuity is essentially a tax deferred mutual fund. But that distinction points out the major difference between a fixed annuity and a variable. With a fixed annuity, the company guarantees a return to the investor irrespective of how well the company actually meets its projections. Under a variable annuity, the annuitant investor selects the various investments offered. Such offerings may be growth stock fund, balanced fund, bonds and money market instruments. The investor makes his/her own selection and also takes all the risk. If the account goes down, too bad. Obviously however, if the fund goes up, none of the earnings are currently taxable and therefore the account can compound tax free over the years to a significant portfolio size. There is however one guarantee being marketed with many variable annuities. Should an investor die with an account value less than his/her contributions, the company will provide to the beneficiaries at least the contribution value. If not presented as part of the annuity contract, the "insurance" may be purchased as a separate item. Some companies are even rebasing the value each year- a risky position should the market experience a long term bear market.
The key to the selection of a variable annuity is the performance. Most have very little track history. There are two major issues to consider. First, if an annuity company starts its OWN fund, it's probably not worth taking the risk since there is no track record to the funds- one of the key issues in the use of mutual funds. Insurance companies understand insurance- that by no means gives them a claim for knowledge of the stock market- though a review of their general account may indicate adequate performance. Second and preferable is where the company contracts with a MAJOR mutual funds where there is significant information on the past history. (Remember that past history is no indication of future results. But it is one of the BEST indicators to start with.) Some of these funds may be CLONES of great funds but that is not/may not be the same as being in the famous fund. Stay with the best funds with substantial track records of at least three years. Do not depend on a six month or one year return as being reflective of ability or ultimate return. As the investor/annuitant, the policyholder is responsible for selecting the various investments and may switch the investments at discretion (subject to the contract). If one does not want the risk or has little or no previous exposure to the stock or bond marketplace, this is NOT the place to start. That statement tends to be shown in recent surveys that shows most "investors" held assets in risk free money market funds (not unlike the statistics of 401(k) plans where approximately 50% of participants used money market funds versus essentially zero with professional money managers. The additional costs of management also seriously erode the value of bond and money market accounts). Such investors have neither the experience or knowledge to use the account properly and if not counseled properly by some outside source- most notably the agent- than this was an unsuitable investment. Some agents might try to guide investors in the selections of the various investments and provide ongoing review for any changes in the economy or fund itself. However, what background does the individual have for such expertise? How well have past recommendations done? Do they understand asset allocation? Minimum designations of CFP or ChFC are mandatory- and even those have relatively little training in investment analysis.
FEES: Insurance companies make money on fixed annuities on the spread between the interest they offer the annuitant to the rate they make. In a variable account, they make it on many other FEES so it pays to read and understand the prospectus. The fund manager may make .75%, while the insurance company may charge from 1.25% to 2% for mortality and expenses.
On top of that they will normally have an annual maintenance cost of $25 and there will be surrender charges as well- similar in design to those on a fixed annuity.
Below are some examples of the various charges on variable annuities. Note the significant difference in fees. Obviusly, fees change all the time so you need to do constant review.
Vanguard Money Market
Annuity Charge .55%
Annual Portfolio Charge .40%
Surrender Charge 1.0%
Fidelity Money Market
Annuity Charge .72%
Annual Portfolio Fee .70%
Surrender Charge 5.0%
Standard Insurance Firm Average Money Market
Annuity Charge .65%
Annual Portfolio Fee 1.29%
Surrender Charge 7.0%
The fees make a huge difference on the accumulation of growth. Additionally, most people are employees of corporations where they have the use of 401(K)'s, IRA's, TSA's and the like. These can be funded with non-tax money up to $10,500 (combined investments in all the retirement accounts). Therefore, variable annuity accounts are primarily for the affluent who want to invest more than $10,500 in a tax deferred mutual fund account.
Caution advised- there is no step up in basis at death and all earnings are fully taxable as ordinary income. Astute investors can actually maximize total future assets by utilizing taxable funds with low tunrovers. (See other articles within this section for further commentary.)
TAXATION: NON QUALIFIED ANNUITIES- where an investor simply gives pre-taxed money to an insurance company- are only taxed on the interest generated by the account when the money is withdrawn. The IRS will not tax the previously taxed money again. There are two methods for the taxation- one as a lump sum (full or partial) withdrawal and the second as an annuity taken over five years or your lifetime, whichever is longer. Under a lump sum withdrawal, any non-taxable money is taxed first. This is known as LIFO or last in, first out. For example, assume an investor had put $100,000 into a non-qualified tax deferred annuity which earned $20,000 in interest over the next few years. If the investor took out $15,000, the IRS views that as all taxable. If he took out $25,000, the first $20,000 is taxable and the remaining $5,000 is a return of previously taxed principal. On the other hand, if the investor decided to take a life annuity, the $20,000 of interest plus interest earned during period is prorated over the annuitization period. If the investor received $10,000 in payments per year, an actuarial formula might show that $3,000 represented interest.
Therefore that would be the amount that would be taxed that year. The other
$7,000 represents a return of principal. If one lived long enough, all principal
would have been returned and payments after that time would become fully
taxable.
IRS 10% PENALTY: In almost all cases, any funds taken out
of an annuity before age 59 1/2 will not only be subject to ordinary income
tax as shown above but an ADDITIONAL 10% PENALTY tax as well. (See your
accountant if you retire early- exceptions might apply.) Therefore if you
are young, it may not be worthwhile to consider an annuity should you need
the money prior to 59 1/2. Some advisers are suggesting to younger investors
that a tax deferred annuity, with a variable mutual fund account and assumed
excellent growth, is a viable investment product even though funds were taken
out prior to 59 1/2 and the 10% penalty was applied. Supposedly the extra
tax deferred growth would more than offset any extra tax. It can work, but
the supposition is based on 10 to 20 years of assumed appreciation which
may not be realistic. Further, you must recognize
basis and how an index mutual fund
might work.
TAXATION OF QUALIFIED PLANS: These annuities are qualified under sections of the IRS code and are usually deducted from your pay by your employer. NONE of the money is taxed. The deduction reduces your tax home pay and your current tax bill since there is less money for the IRS to tax. Since none of the money, principal or interest has ever been taxed, any funds taken out are subject to full ordinary income taxation. The 10% penalty still applies however to most withdrawals before 59 1/2. Many of these plans fall under code sections 503(c)(3) and 403(b) available to non-profit organizations (hospitals, teachers, Red Cross, etc.). The IRS has formulas to determine how much may be deducted each year and is based on a percentage of salary. If too much is put in, substantial penalties apply. Almost all agents in the field have computer programs to determine the correct amount.
ANNUITY PAYOUTS
Unquestionably one of the biggest ERRORS most people make is in the decision to take a monthly payout from the insurance company. The returns vary tremendously and in many cases are absolutely minuscule. And the larger the company, the less competitive it usually is. After all, somebody has to pay for all that advertising. The first issue for review is the type of options that you might find available either directly from the annuity company or as presented by your personnel department as part of your retirement package. The major difference between the two is that if the annuity was part of a retirement pension plan, it MUST include your spouse as a joint recipient of the annuity unless she cancels that right in WRITING. A law was passed, and justifiably so, to prevent the retiring spouse from taking the maximum payment for life but upon the retiree's death, leaving no payments available to the surviving spouse (ERISA).
ANNUITY PAYOUT OPTIONS
Period Certain (3- 30 years)
Joint Life +50%
+66%
+100%
Joint Life +50% + 10 years certain
+66% + 10 years certain
+100% + 10 years certain
Life Only
Life with Refund
Life + 5 years certain
Life + 10 years certain
Life Expectancy Option
Lump Sum
Not all plans have all options. Many do not have lump sum distributions available. The life expectancy is an explained later in detail.
The fewer the restrictions, the greater the payout. With most companies, the life only will be the option providing the greatest payment since the annuitant and the insurance company have a guessing game as to how long the annuitant will live. If the annuitant lives to 100+, the insurance company keeps paying. However, should the annuitant die only two months after monthly distribution commences, the insurance company ceases payments altogether and keeps the funds remaining. The greater the risk, the greater the reward. However, as is obvious, if the annuitant died quickly, the return on the money is negative. If an annuitant put in $100,000, gets only $5,000 of monthly payments and then dies, the insurance company keeps the rest, NOT the beneficiaries (unless contracted otherwise). If the annuitant lived to age 70, the return may only be 4% or 5%. Even if the annuitant lived to 85, the return may only amount to 8%- or not much more yield, if any, than what a CD might have provided. Furthermore, during that entire period of time, the annuitant has had NO access to any of the funds. The contract stated $X per month and that's all that the annuitant is entitled to. If funds were needed of for a medical emergency, long term health care, whatever, tough luck!
The situation is essentially the same under periods certain. A life and 10 year certain means that the retiring worker will get payments for life, but should he/she die within the 10 year period, the survivor will get payments to equal at least 10 years from inception. This may sound conservative, but rarely is. Assume there was $100,000 value at retirement in a company plan, TSA or tax sheltered annuity. If the annuitant should die and 10 years of payments are made, the amount returned might only be $97,000. (Figure obtained from one of the leading insurance companies in the United States.) That's a $3,000 loss. A negative -.60% return. Variations in annuity payments are rarely, if ever, mentioned to purchasers since agents seldom are even aware of the numbers, never mind are conversant in their use. Annuity contracts do NOT contain figures on current payouts (guarantees only). Furthermore, some companies, even when called directly, give out figures that most agents cannot convert to actual dollars or yields the annuitant will get. Agents selling insurance or annuities must be able to use a financial calculator such as the Hewlett Packard 12C.
Below are examples of a survey of 124 major insurers from an A.M. Best review,
February 1990. The disparity in returns is easily apparent. Admittedly, rates
are now much lower and the disparity not as obvious. But even small differences
in monthly amounts can be a Godsend when you are 80 years of age and need
every penny to live on. Admittedly the review is over 10 years old, but the
scenario remains the same regardless of year. There can still be significant
differences in rates when interest rates are lower.
$100,000 Immediate Annuity, Male age 65, A or A+ Best Ratings
Single Life Payout
| Top Company monthly payout | Bottom Company monthly payout |
| $1,080 | $816 |
| 999 | 813 |
| 983 | 803 |
| 967 | 803 |
| 957 | 781 |
The difference between high and low is $299 per month; $3,588 per year; or $107,640 over 30 years. The difference in return between the high and low payments are as follows: Over a 30 year period, the return would be 12.66% high, 8.67% low. Over 20 years the return is 11.69% high, 7.09% low. If you died in 10 years, the high is 5.39%, or a NEGATIVE 1.27% return. Some old annuities have even lower payouts. Although rates are significantly lower in 1991, the disparity will still exist- though at lesser degrees. But in the life only payout, and in other options as well,
1. at no time do you have any rights to the principal and
2. at no time do your beneficiaries get anything.
In many cases, the annuitant would have done better in a tax free municipal bond fund or even a taxable CD. Municipal's currently earn about 7% and are non- taxable. And in both municipal and bond funds, there is access to the monies at any time. Admittedly there is risk because the portfolio may decrease in value but, I submit, there is more risk when one CANNOT get to any funds at all.
After all said and done, are there situations where annuity payouts are viable. Certainly- and two particular instances come to mind. The first involves those individuals who would spend the money frivolously- "mindless spendthrifts" so to speak. Since they cannot be trusted with proper budgeting, it would be preferable to simply give them a monthly check. The other situation is for those individuals who will- at least indicated by heredity- live a very long life. If a good annuity is selected, the return past age 85 or so can be substantial.
LIFE EXPECTANCY OPTION
In certain unique annuities, there is an extra payout option called the Life Expectancy Option. In such cases, the principal continues to earn a current rate of interest- say 8.5%. The annuitant can usually withdraw at least an extra 10% of principal each year without penalty. Whatever is left upon death goes to the beneficiaries.
| Age | Remaining Life Expectancy at Attained Age | Balance at Beginning of Year | Monthly payout | Balance at End of Year |
| 65 | 20 | $100,000 (1/20) | $416 | $102,785 |
| 66 | 19.2 | 102,785 (1/19.2) | 446 | 105,426 |
| 67 | 18.4 | 105,426 | 477 | 107,885 |
| 68 | 17.6 | 107,885 | 510 | 110,123 |
| 69 | 16.8 | 110,123 | 546 | 112,098 |
| 70 | 16.0 | 112,098 | 583 | 113,759 |
| 71 | 15.3 | 113,759 | 619 | 115,107 |
| 72 | 14.6 | 115,107 | 657 | 116,093 |
| 73 | 13.9 | 116,093 | 696 | 116,671 |
| 74 | 13.2 | 116,671 | 736 | 116,788 |
| 75 | 12.5 | 116,788 | 778 | 116,388 |
| 76 | 11.9 | 116,388 | 815 | 115,500 |
| 77 | 11.2 | 115,500 | 859 | 113,986 |
| 78 | 10.5 | 113,986 | 896 | 111,891 |
| 79 | 10.0 | 111,891 | 932 | 109,174 |
| 80 | 9.5 | 109,174 | 957 | 105,924 |
| 81 | 8.9 | 105,924 | 991 | 101,986 |
| 82 | 8.4 | 101,986 | 1,011 | 97,484 |
| 83 | 7.8 | 97,484 | 1,028 | 92,415 |
| 84 | 7.4 | 92,145 | 1,040 | 86,785 |
| 85 | 6.9 | 86,785 | 1,048 | 80,612 |
| 86 | 6.4 | 80,612 | 1,033 | 74,128 |
| 87 | 6.1 | 74,128 | 1,012 | 67,386 |
| 88 | 5.6 | 67,386 | 985 | 60,448 |
| 89 | 5.2 | 60,448 | 950 | 53,390 |
| 90 | 5.0 | 53,390 | 889 | 46,526 |
| 91 | 4.6 | 46,526 | 824 | 39,925 |
| 92 | 4.4 | 39,525 | 756 | 33,657 |
| 93 | 4.1 | 33,657 | 684 | 27,789 |
| 94 | 3.8 | 27,789 | 593 | 22,581 |
| 95 | 3.7 | 22,581 | 508 | 18,023 |
| 96 | 3.4 | 18,023 | 441 | 13,937 |
| 97 | 3.2 | 13,937 | 362 | 10,510 |
| 98 | 3.0 | 10,510 | 291 | 7,698 |
| 99 | 2.8 | 7,698 | 229 | 5,446 |
In the example above, if the annuitant died at age 75, the beneficiaries have the right to $116,388 INSTEAD of the insurance company (restrictions may apply). In some cases the annuitant can get ALL the money at ANY time. That is best contract for almost all annuitants. Retirees need more flexibility and access to funds AFTER retirement than BEFORE simply because too many things go wrong (health is the major concern) and there may be no place else where the assets are available. Many people should/can use an annuity to defer taxes and build up a retirement nest egg. BUT MOST PEOPLE SHOULD NOT ANNUITIZE! They are perfectly legitimate and viable investments for retirees who- as stated- are "mindless spendthrifts". These people would not use/budget the money wisely and need to be restricted to the funds over their lifetime.
There are many current annuities where it is NOT necessary to annuitize anything in order to get the money. There are no restrictions whatsoever. Money may be left in the account upon retirement and simply withdrawn as needed on a monthly basis. This is NOT a form of annuitization. Remaining funds continue to draw interest and are only taxable when withdrawn.
TYPES OF PLANS
TWO TIER vs. ONE TIER: There used to be a major battle in the industry regarding whether one type of annuity is better than another. (If you have a company annuity, there are usually no choices as to the plan type utilized. The problem referenced here exists for those people purchasing their own annuities- particularly in the non- profit 403(b) and 501(c)3 TSA market.) The table below illustrates the problem.
Two tier annuities generally advertise higher interest rates than one tier- for this example 10% was selected. However that interest rate is ONLY applicable if the funds (called the ACCUMULATION value) remain with the company and are annuitized (monthly payments) over the periods allowed by the company. If funds are desired as a lump sum upon retirement, the interest rate on the CASH amount might be only 7%. Over time the difference between the two values increases. On a one tier annuity, there is only one interest rate- say 9%. Once the surrender period is over and funds are requested, the entire amount shown as the account value is available.
Two Tier Plan $400/month; 20 years 10% "accumulation" interest rate and 7%
cash value rate, compounded monthly
YEARS OF PLAN/10% Accumulation
| 1 | 5 | 10 | 15 | 20 |
| $5,026 | 30,974 | 81,938 | 165,788 | 303,747 |
7% Cash Value
| $4,957 | 28,637 | 69,234 | 126,785 | 208,370 |
One Tier Plan $400/month; 20 years, 9% compounded monthly
YEARS OF PLAN/9% Accumulation and Cash Value
| 1 | 5 | 10 | 15 | 20 |
| $5,003 | 30,170 | 77,405 | 151,362 | 267,155 |
(Admittedly the above figures were presented at older higher rates, but the essence is the same.
The tendency most people have in purchasing an annuity is to look solely at the highest interest rate being presented- particularly in this case where the two tier product is earning a full 1% greater than a one tier. The decision is obvious, isn't it? No! Not even close. In the above two tier, 10% example at 20 years, the $303,747 accumulation value is ONLY available if the fund is annuitized. A lump sum withdrawal would result in only $208,370. A lump sum from the one tier is based on "what you see is what you get"- in this case $267,155. That's $58,785 more than the one tier. (In all cases above, surrender charges might apply to a lump sum withdrawal up to about 15 years. Since we are basing a decision on a 20 year period, no surrender fees or back-end loads should apply.)
But then the argument goes that if the two tier product is annuitized (monthly payments taken over a period of time), the monthly amount MUST be more than the monthly payments available under a one tier simply because you started with more money. Nice thought, but the payouts vary so much from company to company (and are usually dismal) that the one tier product with less principal may actually pay more than the two tier. Some states, universities and school districts have banned the use of two tier annuities. Other jurisdictions are at least requiring full disclosure of the inherent problems with two tier products. The issue today might not be with the sale of a two tier annuity but in regards to the retention of such annuity. It might be financially better to switch even though you may suffer a surrender penalty as addressed below. You or your adviser will need a financial calculator to figure this out.
ANNUITY TRANSFERS & ROLLOVERS
Can an annuitant convert an existing policy that does not have the above flexibility or is a two tier annuity and transfer it over? Yes, but penalties probably will be involved. In a two tier annuity, a loss will almost always be encountered because of the ever increasing difference between the cash and accumulation value (only the cash value is transferred in an exchange). Additionally, should the surrender charge still be applicable, it will further reduce the cash transferred. However, many of the annuities to which the sums are transferred will grant a 5% to
15% BONUS to the cash received. This bonus might offset any "losses" the transferee may incur. The younger the participant can transfer the sums to a good annuity giving the flexibility to a complete free lump sum removal upon retirement, the better the bonus and the better the ultimate return. IRS code section 1035 allows the following to be exchanged or transferred without any taxes:
1. An annuity contract for another annuity contract
2. An endowment contract for another endowment contract (subject to
certain conditions.)
3. A life insurance contract for another life insurance contract
4. A life insurance contract for an endowment contract
5. A life insurance contract for an annuity contract.
NOTE: An annuity contract CANNOT be exchanged into a life insurance contract.
Some companies will send the money directly to the new company but due to the "games" being played and the attempt to retain funds, the process could take several months and innumerable letters and forms. Be aware that current tax law REQUIRES that the funds be a direct transfer. Funds CANNOT be received by the annuitant and signed over to the new company.
PENSION MAXIMIZER
Assume that when a worker retires, he/she has the choice of several annuity payout options to select from- and that the lump sum withdrawal was not available. If the worker picked the joint option with 50% survivor benefit, the initial payment might be $2,653. Upon his/her death, the surviving spouse would get $1,326. If the worker picked the 100% option, the initial payment might be $2,338 per month. However at death the survivor would get $2,338. The more the survivor gets, the less the initial payment. But if there were no survivor benefits and the life only
option was selected, the payment might be $2,933 per month. That's a difference of $545 more per month versus the life with 100% option. This extra money could make a significant difference in their lifestyle.
OPTIONS
| Life Only per month | Life with 100% survivor payments per month | Life with 50% survivor payments per month |
| $2,933/2,933 | 2,388/2,388 | 2,653/1,356 |
But you have the problem with the life only payout, that once the worker (we'll assume the husband for simplicity) dies, the wife gets nothing (see spousal release below.). With the pension maximization, the husband would take the life only option paying the most $/month and either buy prior to or at retirement a life insurance policy on himself. The idea is that when the husband died, the wife would have more than enough funds from the insurance to equal or exceed the income available under one of the more restrictive options. In the interim therefore, they have enjoyed the extra monthly income. And should the wife die first, the husband will be able to enjoy the higher payment for the rest of his life and also have the opportunity to draw out loans on the life insurance policy, select another beneficiary, etc. Under the example above, the husband uses the life only payout of $2,933 per month but has purchased a life policy that would supposedly pay to his wife at least $2,933 per month if the lump sum proceeds were invested properly. These might work for certain retirees BUT could be a problem for others. Consider the following:
1. The wife is required to "sign off" on the annuity (she is required to do this under law. The husband cannot unilaterally decline the joint life payout from a company). However she might LOSE any medical coverage or other important benefits (nursing home care) that the company offered to spouses. The extra cost for these benefits can more than offset any perceived gain from the insurance policy.
2. It may be much better economically to maximize payments in voluntary plans (403(b), 501(c)3, 401(k), IRA's) during working years than to even consider pension maximization. And all funds put into these accounts are NOT charged fees for mortality, expenses, etc. that the insurance company must charge.
3. Can the lump sum payment by the insurance company actually yield the same monthly/annual payments as what the annuity could have offered- and for how long? If it supposedly could provide these payments, who is providing the investment analysis? The insurance company? the surviving spouse? friend? attorney? Financial Planner? UFO? Is the portfolio conservative, aggressive, stocks, bonds, what is the A.M Best and S&P ratings?- did anyone really know what they were talking about?
4. The pension payments may contain an inflation index- meaning that they will increase each year. This makes the ability of an insurance product to match payments very difficult.
5. Assuming that the above questions have been adequately addressed, it still will be difficult to buy a policy after the worker retires that is inexpensive enough to offset the pension annuity. After all, costs for insurance of any type at the age of 65 or older are going to be quite expensive. Even if purchased, has a budget shown that the retiree can "guarantee" that there will always be adequate funds to make the insurance payments?
The pension maximization is primarily viable for those people that buy the policy while they are still working, are healthy and can afford the payments. Even then however, one must run the numbers to see if it is economical. In summary, it is imperative to utilize an independent adviser to CAREFULLY review the entire retirement package before a couple would sign off on the survivor benefits. It would seem preferable and far more conservative that a worker maximize his/her opportunities in tax sheltered accounts. In most cases, particularly for those just beginning retirement, pension maximization probably won't work.
INTEREST CREDITING
Many annuity companies are extremely competitive and look for all sorts of methods to get business- or to take it away from other companies. One of the gimmicks or smoke screens is one already addressed- the two tier annuities. Advertising a very high rate when the accumulation value can never be received as a lump sum is "unethical". However there are solid incentives being offered by other companies to induce you to go or STAY with their company or to take old policies from "non-competitive" companies and transfer the money to them. They use a bonus interest system. These incentive programs depend on such things as age, type of product (qualified or non-qualified) and whether the funds are put in as continuing monthly investments (usually called flexible premium or "flex" policies since you can change the monthly contribution) or as a lump sum from another policy (single premium). The many levels of interest crediting may be somewhat confusing, but the adviser must become familiar with the mechanics.
Flexible premium: Under these policies, the annuitant signs a contract where they intend to put in $X dollars per month over a period of time. The annuity company (one tier preferably) contracts that it will pay the annuitant a competitive rate of interest (hopefully) for each sum invested. The annuitant can change reduce or eliminate payments at will. For the most part there are no penalties for a reduction of payments- though, due to the various policies within a company, some require that a minimum contribution be made. If the annuitant ceases payments prior to the minimum contribution, the annuity company may require a change of contracts. In such cases, the interest credited may be lower. In addition, should an annuitant transfer funds from one company to another, some surrender penalties may apply. In the cases mentioned, the ceasing of payments or the transfer of assets incurring surrender penalties tends to indicate poor planning or review of products to begin with. Furthermore, in almost all cases, these are relatively long term investments that should not be (though quite frequently are) changed on emotions and whim of the moment.
OLD VS. NEW MONEY: Assume a company is currently offering 8.5% on any funds now put into the policy and will guarantee that rate for one year (time frames vary tremendously from company to company so it pays to shop around). This initial first year rate is universally a "marketing" rate used to induce business. If there had been an initial payment of $200, there would be $217.68 at the end of one year (compounded annually). But once the year is up, this $217.68 is now considered OLD or RENEWAL money and is put into a pot of the general account of the annuity/insurance. This rate almost always will be LOWER than NEW marketing rates for funds just going into the contract. (The exceptions may be young annuity companies with a new book of business or where the annuity section of the insurance company's business is not a profit center- just used to get customers.) The earning potential of this pot of renewal or old money is really where the annuity company can "make or break" the account. If they had provided very high marketing rates for one year, they can easily take it back in the next 5, 10 or 20 years in the policy simply by giving a low renewal rate. For the most part, interest rates on the old money are not obviously advertised- nor may they even be known to the agent. However, in order to properly analyze a product, SOMEONE- the annuitant, agent or independent adviser- must know how interest is credited and be aware of the underlying consequences. To be fair, the "old Money" rate may be lower simply because the company bought long term bonds over many years where the interest return on these bonds may be lower than current rates in the economy. But the concern in regards to low "old Money" rates is that the annuity company is UNILATERALLY CREDITING A VERY LOW RATE in subsequent years to either offset the high marketing rate- or more likely- to simply increase its yield at the expense of the client. Understand that the companies make their profit on a spread between what they give to the client and what they earn on the investment of the funds to the company. This policy is currently being conducted by some firms and actively sold since the agents don't know, don't care or are being offered excessive commissions and free trips. (Literally all insurance and annuity companies offer agents special sales incentive trips throughout the world. The practice fosters sales of products undeniably in instances where the trip is the motivation- not doing the best job for the client. Additionally and quite obviously, consumers are paying for all these "extras". Consumers would be well advised, in the review of their agents, to ask how many trips he has been on. I submit, the more the trips, the more caution is advised in their use. ) It is imperative that any review must analyze past company performance to determine what OLD/RENEWAL monies have actually earned in the past. Some of the reputable companies have felt unfairly impacted by this recent discussion of "old money" rates and are not guaranteeing their "old money" rates. For example they might guarantee that OLD money rates will never be less than 1% less than the rates offered on NEW monies. If interest rates on new money was 9%, OLD money rates could never be less than 8% during that same time frame. This is a step in the right direction.
RATES DURING ANNUITIZATION: After all the problems with interest crediting while money is put into a policy, there can still be a considerable loss of funds during the payout. In fact, the period of annuitization (assuming no lump sum or life expectancy option selected) is, in many cases, longer than the time period of accumulation. A company may offer dismal rates for annuitization- some as low as a NEGATIVE RETURN- thereby effectively eliminating the gains during accumulation.
Here is an actual example for a male age 68 with a normal actuarial lifetime of another approximately 14 years.
Life annuity with 15 year guaranteed period....2.11%
Life annuity with 10 year guaranteed ..............0.27% (-2.89% over the
10 years)
Life annuity with 5 year guaranteed ................1.07% (-22% over 5 years)
15 year annuity certain ....................................4.20%
10 year annuity certain ....................................4.39%
5 year annuity certain ......................................4.68%
BONUS INTEREST AND BONUS PRINCIPAL
As with some pure insurance products, annuity companies are offering added or "bonus" interest to induce an annuitant to initiate a contract- and stay there- or, in particular, to take a lump sum from one company and transfer it to them. There are a couple of issues to review with each of these formats.
Flexible Premium: With added interest on a flexible premium
policy (putting money in over period of time), the company will grant the
annuitant the extra interest immediately upon receipt. This extra interest
may be one or two percent. BUT the annuitant will only get this extra interest
IF they remain in the account at that company for a minimum period- say ten
years. If the policy is surrendered or transferred to another company, none
of the extra interest may be credited to the account. This type of offering
may be deceptive however in that the bonus only disguises a lower overall
rate as compared with other plans. After a period of time has passed, the
plan with a slightly higher overall rate but with no bonus will win out.
For example, review the chart from Life Insurance Selling. It clearly
demonstrates why bonus interest can be misleading.
The top scale represents the First Year Bonus. The vertical scale represents Base Rate. The interior numbers represent $100,000 in seven years and are based on annual base rate renewals.
| 0.00% | 0.50% | 1.00% | 1.50% | 2.00% | 2.50% | 3.00% | 3.50% | 4.00% | 4.50% | 5.00% | |
| 4.25% | 133,824 | 134,465 | 135,107 | 135749 | 136,391 | 137,033 | 137,675 | 138,316 | 138,958 | 139,600 | 140,242 |
| 4.50% | 136,086 | 136,737 | 137,388 | 138,040 | 138,691 | 139,342 | 139,993 | 140,644 | 141,666 | 142,688 | 144,987 |
| 4.75% | 138,382 | 139,042 | 139,703 | 140,363 | 141,024 | 141,684 | 142,345 | 143,005 | 143,666 | 144,326 | 144,987 |
| 5.00% | 140,710 | 141,380 | 142,050 | 142,720 | 143,390 | 144,060 | 144,730 | 145,400 | 146,070 | 146,740 | 147,410 |
| 5.25% | 143,072 | 143,751 | 144,431 | 145,111 | 145,790 | 146,470 | 147,150 | 147,289 | 148,509 | 149,189 | 149,868 |
| 5.50% | 145,468 | 146,157 | 146,847 | 147,536 | 148,226 | 148,915 | 149,604 | 150,294 | 150,983 | 151,673 | 152,362 |
| 5.75% | 147,898 | 148,597 | 149,296 | 149,995 | 150,695 | 151,394 | 152,093 | 152,793 | 153,492 | 154,191 | 154,891 |
| 6.00% | 150,364 | 151,072 | 151,782 | 152,491 | 153,201 | 153,910 | 154,619 | 155,328 | 156,083 | 156,747 | 157,456 |
| 6.25% | 152,863 | 153,582 | 154,301 | 155,021 | 155,740 | 156,459 | 157,179 | 157,898 | 158,617 | 159,339 | 160,056 |
| 6.50% | 155,399 | 156,128 | 156,858 | 157,587 | 158,317 | 159,047 | 159,776 | 160,506 | 161,235 | 161,965 | 162,694 |
| 6,75% | 157,970 | 158,710 | 158,710 | 159,450 | 160,929 | 161,669 | 162,409 | 163,149 | 163,889 | 164,629 | 165,369 |
| 7.00% | 160,578 | 161,328 | 162,078 | 162,829 | 163,579 | 164,329 | 165,080 | 165,830 | 166,581 | 167,331 | 168,081 |
So what's the deal? Assume someone gives you a base rate of 5.50% but with a 4.00% first year bonus. Looks great with an advertisement of 9.50% the first year. The other agent only has a 6.25% overall rate and NO bonus. In seven years with the bonus, you would have $150,983. But if you had taken the 6.25% rate, you would have had $152,863. While not a huge difference, the difference gets larger and larger as the years roll by.
Single Premium: In such cases, the annuitant may wish to transfer an account from an annuity company offering less than competitive rates or where a two tier product is utilized. As previously stated, there unquestionably are losses or penalties on such a transfer. The loss will be at least the difference between the cash and accumulation values in two tier products (amounting up to 20%+) coupled with possible surrender charges if the account has not been held that long at the previous company (though surrender charges may last twenty years or more). The annuitant however has to consider whether the move is "economical"- in that the new companies higher interest rate may never be able to offset the loss on the original account (no other considerations being regarded). As an additional incentive therefore, the new annuity company may offer a bonus on PRINCIPAL up to 15%.
As an example, let's consider a two tier annuity account with $100,000 in accumulation value and $90,000 in cash value. The annuitant would obviously lose $10,000 in a transfer. By the same token, a one tier account could have $100,000 but be subject to a 10% surrender penalty. In the worst case scenario, both charges might apply- a reduction in value and a surrender charge. However, if we simply assume that only $90,000 of a two tier account would be transferred, most annuitants would not make the change. In order to induce this change, some annuity companies have offered bonuses on any principal transferred to their account- from 5% to as high as 15%. $90,000 x 1.15 = $103,500. This more than offsets any loss on the transfer but certain conditions are applied to the account. The extra bonus is available only if the annuitant remains in the policy for a specified period of time- say 15 years. Prior to that, the annuitant may receive none of the extra interest or perhaps a partial amount (some interest may be available if the account is annuitized). The annuitant must also be aware that a new surrender period also starts.
If an annuitant will not be in the accumulation period for 15 years prior to retirement (applicable for those 50 years of older), then the policy granting the higher bonus may not be preferable since flexibility may be lost. In these situations, the annuitant may consider the policy granting a 5% bonus. These have shorter surrender charges and provide more flexibility such as allowing full pullout of all funds in 10 years with no penalty. There are many variations with more products being presented each month. IF an adviser KNOWS what they are doing, they can substantially increase an annuitant's retirement funds with NO risk.
In summary, annuities may work during the accumulation stage but one must recognize the issues of basis upon receipt of the funds. Ordinary income tax may be higher than the capital gains tax from other types of alternative investments. Further, the annuity returns during annuitization may be dismal- even negative- and the figures are NOT provided by the insurance company. Use of the HP12C calculator is mandatory if one is to utilize an annuity correctly and objectively.
"Ghost of Bubbles Past: Equity Markets Haunt Variable Annuities" by Moody's 2002
WRONG! WRONG! (Johnathan Clements WSJ 2003) Regarding, "Suppose a 65-year-old woman invested $100,000 in an immediate-fixed annuity. That would buy her monthly income of $613, according to Berkshire Hathaway's Web site (www.brkdirect.com). True, that's equal to a 7.4% yield, far above the 4% yield on 10-year Treasury notes."
It's totally wrong. If you are getting simply are return ON your money, the yield on a Treasury is fine. But you get your money back.
You do NOT get your money back in an annuity as a lump sum- you are getting part of your capital returned on an monthly/annual basis and reflects part of the monthly payment. There is not an insurance company anyplace that can offer a 7.4% return.
How do you figure the return? It's $100,000= present value (pv); $613= monthly return (pmt). Then you need n= periods of time. How can you figure that when you don't know the actuarial lifetime of a 65 year old woman? Simple, you use standard life tables. Rounding to 20 years and searching for return (i), the actual return is 4.17%- a far cry from 7.4%.
So the annuitant gets the same return as a current treasury and loses the flexibility for the next 20 years in case something goes wrong. That's not good planning at all. In fact, your presentation is a complete distortion of the facts and requires a correction.
As for "according to Berkshire's Web site, a 75-year-old woman who invested $100,000 in an immediate-fixed annuity would get monthly income of $785, equal to a 9.4% yield." Nope again.
The woman has a 12.2 year actuarial lifetime. It ends up at a 2.3% annualized return. She is getting her $100,000 BACK over the 12.2 years (or whatever the company projects). She would have to live "forever" in order to get a true 9.4% return.
If you disagree, consider this. $100,000 over 12.2 years with a monthly payment of $683. Tell me what the true return is?????
I teach this "stuff"- HP12c calculations, annuities, insurance, CFP training, investments, continuing education and run the largest financial planning site designed for consumer protection. I would nail an agent to the wall for doing what you presented- it is deceptive, wrong and will really screw up somebody's retirement life. It's the reason insurance gets such a bad name (most cases deservedly) since the figures have no real life application. Please correct."
ANNUITY VENDORS BEWARE -- The NASD has fined an Aegon unit $125,000 for having inadequate procedures for its sale of variable annuity products and handling of customer complaints and released an investor alert, titled: "Variable Annuities: Beyond the Hard Sell,"
Annuities: (2003) ACLI's "Profile of Immediate Annuity Owners" reports that 64 percent of owners have annual household incomes of less than $50,000 and 63 percent have no pension income.
"Middle-income consumers are creating their own personal pensions with annuities," said ACLI President & CEO Frank Keating. "And the guarantee of regular retirement income drives up consumers' satisfaction level with the product."
Immediate annuities provide periodic payments for an agreed-upon time span - from a fixed period such as 10 years up to a lifetime - in exchange for a single lump-sum premium or a series of premium payments. People who choose a lifetime annuitization payout option cannot outlive their income. Joint and survivor annuities ensure an income stream as long as the annuitant or the beneficiary is alive.
Among other findings in the report:
* The most common source of funds for buying an immediate annuity was non-tax qualified savings (54 percent), i.e. savings separate from that in an individual retirement account (24 percent) or a retirement savings plan at work (26 percent), such as a 401(k).
* Nearly three-quarters of owners have an immediate annuity with a lifetime payment period (71 percent).
* Most owners bought their immediate annuity (46 percent) because it provides a source of regular monthly income.
* Owners are quite satisfied with their immediate annuity: 22 percent rate it as one of the best financial decisions they ever made, and 60 percent think it was a good financial decision.
"The report provides a fresh look not only at who owns immediate annuities, but the reasons why they were purchased, and owners' levels of satisfaction with their annuities.
"The report on immediate annuity owners offers valuable information to millions of people planning their retirements now. It shows that the choice to receive regular income from an annuity boosts your financial security in retirement."
Yes, regular income is nice. But not if it pays 2.5%. And you lose all access to the funds during retirement when STUFF happens.
Underwriting Impaired Annuities 2003
WSJ just plain wrong: (2004) Johnathan Clements does put out some decent stuff. But, as noted several months ago, his understanding of annuities is patently dismal. He indicated this: while $500,000 invested in 10-year Treasurys would generate income equal to more than $1,800 a month, you might garner $3,400 if you purchase an annuity. Wrong. It is true that the Treasurys would pay INCOME of $1,800. But the annuity does NOT pay pure INCOME. True, part of the monies is income but the other part is a return of non guaranteed principal. So you say one is higher than the other so why not use the annuity? Well, just take part of the principal from the 10 year Treasury so it equals the same $3,400. Further, if you died, you get back the rest of the Treasurys.
Private annuities: (WSJ 2004) Private annuities also come with three big tax benefits.
First, the money transferred to your kids immediately reduces your wealth, which could mean handsome estate-tax savings down the road. There also isn't any gift tax owed, because you are cutting a deal with your children, rather than making them a gift. But to avoid hassles with the IRS, you cannot have any medical condition that suggests you are likely to die within the next year, Mr. Lange warns.
Second, as with an annuity bought from an insurance company, you will have to pay income taxes on only a portion of the sum you receive each month from your children. The reason: Part of your annuity income is a return of principal, and thus isn't taxable.
Finally, you can fund a private annuity with appreciated assets. Suppose you plan to pay for your annuity with $500,000 of stock with big unrealized gains. If you bought an annuity from an insurer, you would have to sell your shares and pay the capital-gains taxes, leaving you with less money to fund the annuity.
But with a private annuity, you don't have to take this tax hit. Instead, you could simply hand over the shares to your children. For your kids, the cost basis becomes $500,000, which means they could immediately sell and pay no capital-gains taxes.
This maneuver, however, does boost the tax bill on the annuity payments you receive. Your monthly payments will now be a mix of income, capital gains and return of principal.
VARIABLE ANNUITY SALES PLAGUED BY ABUSE (2004) - Jonathan Stempel - The nearly $1 trillion variable annuities business is riddled with abusive sales practices, leaving many investors poorly informed about the investments and their fees, risks and tax consequences, U.S. regulators said on Wednesday. A 29-page report from the Securities and Exchange Commission and the NASD said regulators have received a "large number" of complaints from individuals, including many senior citizens, who bought such variable products as annuities and life insurance. The report said the people claimed they didn't understand what they were buying, or that the products were inappropriate for their investment objectives.
"It is critical that broker-dealers ensure that the securities they sell are appropriate for the individual investor," SEC Chairman William Donaldson said in a statement. "Given the complexity of variable annuities, extra care is required.... Many firms should take steps to improve their practices."
Variable annuities are contracts offered by insurance companies and often bought as retirement investments, with taxes deferred until withdrawal. Premiums are often invested in mutual funds. Owners receive regular payments, with a guaranteed death benefit. The SEC and NASD "have a number of ongoing investigations related to sales of variable annuities
FEES, COSTS - The report said high commissions, typically exceeding 5 percent, drive sales of variable annuities. Last year Americans held $985 billion in the product, up more than 20 percent from a year earlier. But variable annuities can be costly to own. The report said the insurance wrapper drives annual expenses to between 1.3 percent and 2.2 percent. Investors may also be forced to pay surrender charges as high as 8 percent if they withdraw money within a specified period, often seven to nine years.
In contrast, Morningstar Inc.'s database shows that the average mutual fund, which lacks insurance protection, charges 1.4 percent a year. Surrender charges, known as redemption fees, rarely exceed 2 percent, when they exist at all.
The report said some brokers improperly pushed products that required people to mortgage their homes, or sold high-risk products to people with low risk tolerance. Some brokers also sold illiquid variable products to people who needed money soon, and thus would likely face surrender charges. Still other brokers, meanwhile, conducted "excessive switching" of annuities, which can drive up commissions, and gave false or misleading justifications for doing so. The NASD, formerly known as the National Association of Securities Dealers, in April proposed revamping rules governing variable annuities sales, including greater disclosure and training of brokers.
Indexed annuities. (2006) Do they work? You decide
This is the only chart I have seen that definitively shows what would have happened given the different structures and different time frames. Very informative
ANNUITY SETTLEMENTS (2006) – It may not have as large a market as life settlements, but apparently annuity settlements do have a place. A secondary market for annuities is emerging, giving investors the opportunity to sell what was once unsalable or cash in their annuities for more than the insurer would give them. "We estimate that up to 10% of annuity holders would sell their policies if they could," says J.G. Wentworth, one of a handful of firms that buy annuities from individuals. In fact, an American Council of Life Insurers (ACLI) survey of 460 annuity holders reports that 27% are concerned that they may be unable to sell their annuity if they want the money for something else.
Equity INdex Annuity (2007) Quiz 1.) What annual reset credit method can show a Zero return in 5 of the last 10 years? (S&P 500 Index assumed)
A. Monthly Average
B. Monthly Cap
C. Daily Average
D. Annual Point to Point
2.) What credit method below earns the greatest amount of interest over the troubled 1970s? (S&P 500 index assumed)
A. Monthly average with a 1% spread
B. Monthly average with a 12% cap
C. Monthly average with a 90% participation rate
D. a Fixed rate of 5%
3.) A comprehensive study published in November 2006 showed that using rolling ten-year periods of the S&P 500 index starting in 1967, EIA credit method performance between best and worst would have varied by how much?
A. less than 1/2%
B. 1%
C. 2%
D. over 3%
4.) If your client expects to see results that closely mirror the stock index performance, which credit method should you use?
A. Annual point to point
B. Daily average
C. Monthly cap
D. Monthly average
5.) True or False: Choosing an EIA that offers an immediate bonus on the premium deposit assures a higher ending value.
A. True
B. False
Answers 1.) B. Monthly Cap, when a typical 2% cap is used. Increasing the cap to 3% reduces the number of zero years to 3.
2.) A. Monthly average with a 1% spread. $10,000 deposited in an EIA using this method in January 1970 would have grown to $17,082 by January of 1980. The same amount earning a fixed 5% rate would have grown to $16,289. Worst performer? The 12% cap. It yielded just $15,692.
3.) D. Over 3%. In this study of 16 popular credit methods, the best credit method yielded an average annualized return of 7.17% and the worst credit method's annualized return was 3.72%.
4.) A. Annual point to point. This method behaves most like the index as quoted in news sources when no caps or fees are applied; instead the participation rate is less than 100%.
5.) B. False. Although an upfront bonus may be a tempting way to recoup losses realized in other investments, the trade off is usually reduced credit method rates.
Corporate owned annuities: (2007) Under the corporate insured annuity strategy, the corporation would buy and own an income payout annuity and life insurance policy on the shareholder. One of the immediate drawbacks of a corporation owning an annuity on the life of a shareholder is the annuity does not qualify as a prescribed annuity, as regulation 304(1)(c)(iii) states that the holder of a prescribed annuity must be an individual, testamentary trust, or spousal trust. Therefore, a corporateowned annuity does not receive the preferential prescribed annuity tax treatment, and the corporate-owned annuity will have a variable amount of taxable income every year. The good news is that the amount of taxable income will decrease each year the payment is made, as future payments will be made up of a larger capital component, and a lower investment component.