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California Annuities

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Lesson 1Historical Development of

Annuity Contracts


History of Annuities

One of today’s most popular financial planning tools is also one of the oldest.

The first historical mention of annuities is found in Roman contracts called annua, which is Latin for annual income or payment.

Roman citizens of means made one-time payments to the government and received lifetime annual payments in return.

In Medieval times the concept surfaced again, this time as a vehicle for raising the funds for war and conquest.

Citizens could purchase a share in a financial program such as England’s State Tontine, established in 1693, nominating another individual, often a child, as the recipient of an annuity that continued until death.

Lesson 1: Historical Development of Annuities

Sporadic uses of the annuity concept can be found early in American history, but the first significant use of annuities can be traced to The Pennsylvania Company for Insurance on Lives and Granting Annuities, which first offered annuities to the general public beginning in 1912.

The stock market crash of 1929 and the depression of the 1930’s led to record sales of annuities, as Americans’ distrust of the stock market created an impression of insurance companies as a low-risk alternative.

These annuities were little changed from their predecessors. Investors would make a single lump-sum payment, which would grow at a fixed rate during a period of years.

Upon withdrawal investors could choose from a fixed payment amount over a period of years or a smaller, guaranteed annual payment for life.



After World War II one of the first innovations in annuities was introduced in the form of the variable annuity. Variable annuities offered contract holders a return on the annuity assets that could be expected to rise with inflation.

Instead of receiving the difference between the investment return and the interest guaranteed to the policyholder, the insurance company charged specific fees documented in the contract.

The policyholder received the entire return from investments such as long-term bonds or equity securities held under the policy less the company’s fees.

The result was higher returns for policy holders when the investment value increased, but in return the risk of loss was transferred from the insurance company to the policy holder.



The first variable annuities created securities and tax problems. Was a variable annuity an “annuity,” and exempt from registration under the Securities Act of 1933, or a “security” subject to such registration? Also, should companies that issued such annuities be considered “insurance companies,” and therefore exempt from the Investment Company Act of 1940? How should year-to-year gains in variable annuity accounts be treated from an income tax standpoint?

It took the Supreme Court to determine that variable annuities are to be considered securities, not annuities, for purposes of the federal securities laws. Congressional legislation was required to resolve income tax issues raised by the creation of variable annuities. The Life Insurance Company Income Tax Act of 1959 (“LICITA”) recognized the existence of variable annuities for federal tax purposes, ensuring annuitants would not be liable for income tax on the growth of variable contracts prior to annuitization as long as no payments were received during the accumulation period.



The more recent introduction of equity-indexed annuities, which allow owners to participate in stock index gains while limiting risk due to a guaranteed minimum interest rate, has further broadened the applicability and appeal of the annuity instrument.

Today annuities are a popular vehicle for achieving any number of financial goals and are available in many formats, each of which offers distinct features. Deciding which annuity is most appropriate for a certain individual’s situation is a complex matter, often requiring the assistance of a licensed representative.

Annuity sales of all types are strictly regulated by federal and state authorities. Financial services representatives who sell annuity products must be well educated in all current regulations, and must meet mandated continuing education requirements in states such as California.



Before defining an annuity in more depth, it’s important to understand why annuities are receiving so much attention and why they’re being purchased in record numbers. In 2001, sales of annuities totaled 184 billion. More than 25 million fixed annuity contracts were in force at the end of 2001. Further, annuity contracts in the benefit paying (annuitization) phase paid out more than $68 billion in benefit payments in 2000.

In 2001 variable annuity sales totaled nearly $113 billion, down from a record $137 billion in 2000. Life insurance industry figures show that over 19 million individuals were covered by variable annuity plans at the end of 2000. By way of historical perspective, in 1985 variable annuity sales totaled a mere $4.5 billion. By 1990, that figure had increased to $12 billion and in 1993, total variable annuity sales amounted to $43.5 billion. At the end of 2001 there were nearly $883 billion in total variable annuity assets, down from $956 billion at the end of 2000.

Market Overview


Although the equity-indexed annuity is new and reliable sales figures are difficult to find, it has been estimated that 2000 sales of EIAs totaled about $5.4 billion with sales reaching $6.4 billion in 2001.

In the past several decades, annuity sales have made up an increasing portion of the total premiums received by life insurance companies.

In 1976, annuity considerations made up only 21% of all premiums received by life insurance companies.

In 2000, annuity considerations accounted for over 56% of the total premiums received by life insurance companies.

Market Overview


In recent years, baby boomers – Americans born in the years following World War II – have begun reaching the age when retirement planning becomes a priority.

In 1980, only 11.3% of the U.S. population was 65 years of age or older, but by 2000 that figure had risen to 12.4% By 2025 population experts predict that 18.5% of the country’s population – nearly one person in five – will be at least 65 years of age.

Many boomers are coming to realize that Social Security and their employer-provided retirement plans will not be sufficient to provide the type of retirement they desire. In fact, a recent survey found that retirement planning is the benefit that employees say that they want and need the most – even more than health care.

Market Overview


Nonqualified annuities are one of the best ways that individuals have to set aside money on a tax-deferred basis. While the premiums paid into this type of annuity do not result in a current income tax deduction, the premiums and the interest earned on these funds accumulate on an income tax deferred basis. And, unlike employer-provided plans, anyone can purchase an annuity and contribute any amount of premium (subject to certain maximum premium limitations imposed by some insurance companies).

In addition to their wide availability, nonqualified annuities offer those planning for retirement investment options that may keep pace, or even out pace, inflation. Variable annuities with their myriad of stock, bond, and other investment accounts are especially attractive for this reason. Additionally, the new EIA provides those looking toward retirement with another useful planning tool.

Market Overview


Although retirement planning is the not the only use for nonqualified annuities it is the one of the most popular. Charitable planning and education funding are two other frequent uses for nonqualified annuities.

Annuities can help with the concern of not saving enough to meet needs during retirement.

Whether or not people are saving as much as they will need – or want – for retirement often depends on how accurate they are in projecting their needs. According to a Retirement Confidence Survey, only a little more than 20% of workers say they are very confident of having enough money to live comfortably throughout their retirement years. Another 45% say they feel somewhat confident. A good question is, “do these survey respondents actually understand how much money it will take to meet their definition of “living comfortably” or even how long of a period they need to plan for?

Market Overview


When asked if they had tried to calculate how much money they will need to save for their retirement years, only around 37% of working people responded positively. When asking couples together, 43% responded that they had calculated their needs for retirement.

Of those who have tried to figure out what would be needed, 15% estimated the need to be less than $250,000; approximately 7% responded the need to be between $250,000 and $499,999; around 9% thought they needed to save between $500,000 and $999,999; while 17% believed they would need more than $1,000,000 to retire in the manner they envision.

And even though they responded that they had calculated the need, 36% were unable to provide the result of their calculation, while another 3% were unable to perform the calculation.

Market Overview


Workers appear to underestimate the proportion of their pre-retirement income they will need to live comfortably in retirement. Half of workers expect that they will need less than 70% of their pre-retirement income; 16% anticipate needing between 70 and 79%; and less than 20% estimate needing 80% or more of their pre-retirement income to live comfortably.

A key reason that workers underestimate their retirement needs are anticipated plans to continue working in some capacity after retirement. Seven in ten workers believe they will continue to work in some capacity for pay after they retire – which is almost three times the number of actual retirees who indicate they actually worked for pay after retirement. Seven in ten workers also indicated they expect either full-time or part-time employment to be a major (20%) or minor (50%) source of retirement income.

Market Overview


This contrasts with the experience of actual retirees, with only three in ten reporting that employment is a major (8%) or minor (20%) source of retirement income.

It appears that today’s workers have an expectation that they will enjoy good health well into their retirement years, which may not meet actual experience.

Couple this with the fact that the number of retirees interested in working will increase significantly as baby boomers continue to retire, and one may conclude that planning for post-retirement employment to be a relied-upon source of retirement income may prove unwise.

Market Overview


These findings indicate that there is a strong market for annuities utilized to provide an income stream during retirement.

Those who are not saving enough can benefit from the readily available annuity products for long-term savings and the tax deferred nature of annuities.

Those who do not how to allocate their premiums can benefit from professional money management, diversification, and other features of variable annuities.

Those whose savings and investment actions fall short of their plans can benefit from the availability of annuity payout options that maximize the income that can be produced from the capital available.

Market Overview


While some people prefer not to dwell on how much they can accumulate and how much income can be produced from it, the fact is, some will have a nagging concern over whether things will work out as well as they anticipate.

Some people want to know in detail how to make the money they have accumulated last as long as they live. Annuities offer solutions for these scenarios.

The values in an annuity can be annuitized essentially at any time. The payments can be set up to last for a specified period of time or for the life of the annuitant.

This feature makes annuities extremely valuable in retirement planning and creates a strong market.

Market Overview


Attachment I – Annuity Legislative History

Understanding of the history of annuity legislation is significant. It provides the evolutionary changes for each law throughout the years. It is important to know what impact changes to legislation have had on annuity insurance.

To view a list of changes to legislative history, click here.


https://clients.pinpointglobal.com/NUCO/upload/attachmentI.pdf

Lesson 2The Primary Uses of Annuities


Definition of Annuities

An annuity is defined as the liquidation of a principal sum to be distributed on a periodic payment basis to commence at a specific time and to continue throughout a specified period of time or for the duration of a designated life or lives.

Annuities are valued tools for retirement planning. In this lesson, we will review the uses of annuities and also consider alternative financial planning vehicles used to help fulfill consumer’s retirement goals.

Lesson 2: The Primary Uses of Annuities

Primary Uses of Annuities

Since the annuity’s unique feature is to provide a stream of payments that cannot be outlived, annuities are frequently used as a tool to provide for a monthly retirement income. However, annuities can be used in many other ways.

· Annuities allow an individual to take advantage of tax-deferred accumulation of interest, since the interest earned inside an annuity is not subject to taxation until it is withdrawn.

· An annuity is an investment that can be used as collateral for a loan.

· Annuities provide a fairly high degree of liquidity, meaning owners can withdraw funds within certain limits during the accumulation phase.

· An annuity can be a useful estate planning tool for people who want to pass on a large sum of money to an heir that is not subject to probate and cannot be contested by a will.


· To create an appreciating asset that does not require any care and feeding (such as dividing money between accounts, etc.)

· As an alternative to an IRA, particularly since there are no IRS limits to the amount which can be contributed annually as there are with IRAs.

· Annuities are very useful for conservative investors whose primary goal is to preserve funds yet still earn a guaranteed level of interest over a long period of time.

Primary Uses of Annuities


Retirement Planning

Although the annuity can be used for many purposes, probably its best and most frequent use is retirement planning.

Retirement has been the focus of much attention in recent years.

Since people are living longer than at any prior time in history, there are more retirement years to be planned for and paid for.

Americans of the baby boomer generation, those born between 1945 and 1964, are quickly nearing retirement age and have begun planning for their retirement years in earnest.

Further, the downsizing of major American corporations is symptomatic of an economy in which employees cannot rely on their employers to finance their retirement.


As a result of these and other factors, there has been a steadily increasing interest in the financial aspects of retirement.

Most Americans expect to receive Social Security benefits at retirement, and many are participants in qualified retirement plans provided by their employers.

Experts warn, though, that if baby boomers are to afford the retirement lifestyle they seem to want, these two sources of retirement income will not suffice.

Personal savings must make up the difference.

Retirement Planning


Retirement: Accumulation Planning

One of the best vehicles for accumulating funds to supplement retirement income from Social Security and qualified retirement plans is a nonqualified annuity.

The use of the labels “qualified” and “nonqualified” refer to whether the annuity is used as part of a retirement plan that is “qualified” under certain sections of the Internal Revenue Code.

A qualified annuity is one that is used as part of, or in connection with, a qualified retirement plan. A nonqualified annuity is one that is not used as part of any qualified retirement plan.

If the annuity is labeled nonqualified, this simply means that it may be purchased by any individual or entity and is not associated with an employer-provided plan.



As with many financial planning strategies, earlier is better than later when deciding to save for retirement.

To illustrate, consider annuity holder Mrs. Smith, who begins saving for retirement at age 40. She will have accumulated $138,598 by age 65 by saving $200 per month, resulting in a monthly benefit of $812.

The same monthly amount started at age 50 would result in a retirement sum of $58,164. Waiting until age 60, with retirement only five years away, severely cuts down on the available funds, resulting in a sum of only $13,954. Under the annuity started at age 50, the monthly benefit would be $341, while under the annuity started at age 60 she would receive only $82 each month.


Age When Premium Payments

Begin

Amount Accumulated

at Age 65

Amount of Monthly

Annuity for Life

40 $138,598 $812

50 $58,164 $341

60 $13,954 $82

The usefulness of starting early can be illustrated another way. Assume that Mrs. Smith, with the help of her financial planner, determines that she needs $500 per month at retirement to supplement her retirement income from other sources.

If Mrs. Smith begins paying premiums into the annuity at age 40, she will need to pay a monthly premium of $123 in order to accumulate the $85,320 that will pay her a life income annuity of about $500 each month beginning at age 65.

If she delays starting the payments until age 50, she must pay $293 each month; while waiting until age 60 would require a monthly payment of $1,223. Clearly, starting early is the best course of action for this type of retirement planning.



Monthly Annuity at Age 65

Accumulation Amount Needed at Age 65

Age When Premium Payments Begin

Amount of Monthly Premium

$500 $85,320 40 $123

$500 $85.320 50 $293

$500 $85,320 60 $1,223

Retirement: Distribution Planning

With the large number of baby boomers hitting retirement age, a great deal of attention has turned to looking at ways to help retirees receive their retirement benefits. One term used for this type of planning is “income distribution planning.” This activity of planning to receive funds is, in some ways, the opposite of planning to accumulate retirement funds, which has received far greater attention.

With the ability to provide a life-long income stream that an individual cannot outlive, annuities can be an ideal vehicle for income distribution planning. Most annuities offer payout options as part of the contract. Thus, an annuity holder can typically elect to receive the funds in an annuity over his lifetime, over the lifetimes of the annuity holder and his spouse, over a certain number of years, in a certain monthly amount, or according to one of several other alternatives typically available. Other names for these payout options are settlement options and payment contracts.


To illustrate a basic method in which a nonqualified annuity can be used for distribution planning, consider a scenario featuring Mr. Jones, age 62, who has decided to retire from his accounting position.

Over the years Mr. Jones has contributed to the retirement plan offered by his employer and, in addition, has made a modest monthly contribution to a nonqualified annuity.

This annuity now has a value of $35,000. If Mr. Jones elects, under the annuity contract’s settlement options, to receive this amount over his lifetime, his monthly benefit will be approximately $235. He will receive this amount each month for the remainder of his life, regardless of how long this ends up being.



Since a nonqualified annuity can offer a greater degree of flexibility with regard to distribution than can many employer-sponsored qualified plans, the nonqualified contract can be a useful distribution vehicle for individuals who wish to begin receiving retirement benefits earlier than the typical retirement age.

Many qualified retirement plans assume age 65 as the age at which retirement benefits can commence. Even if a plan participant can begin receiving benefits before age 65, the amount of the benefit may be less than it would be at age 65.

Also, delaying the start of Social Security benefits will result in a greater amount of monthly benefit and this may be an attractive alternative to some individuals.



Suppose an individual wants to retire at age 55-1/2 or wishes to take another job, start a business, or engage in some other activity that will result in less income than was previously received.

If the individual has a nonqualified annuity, he might consider using these funds as income over the next ten years until age 65.

To illustrate, let’s assume that Mr. Black is now age 55 and wishes to leave his regular job and start his own painting business.

He has both a defined benefit and a 401(k) retirement plan through his employer, but can’t begin receiving full retirement benefits from these plans until he reaches age 65.



If Mr. Black has been contributing to a nonqualified annuity, he can consider using these funds to supplement his income from his start-up business for the next ten years. He can do this by electing a ten year term certain settlement option payout from the annuity contract.

Another option would be to move funds currently in his annuity to an immediate annuity that would pay benefits over the next ten years.

Assuming Mr. Black’s current balance in the nonqualified annuity is $50,000, a ten year payout would result in about $465 per month.

At the end of ten years, the funds in the nonqualified annuity will have been used up but Mr. Black will then be able to start receiving retirement benefits from his previous employer’s qualified retirement plans.



Another possible use of the nonqualified annuity in the distribution phase of retirement capitalizes on the fact that not all of the benefit payments received from a nonqualified annuity are currently taxable.

As will be explained in Lesson 7, with a nonqualified annuity only a portion of each benefit payment will be taxed. The other portion is considered a return of principal and is therefore not taxed.

In contrast, with most qualified retirement plans and traditional IRAs, the benefit payments are fully taxable. Thus, if a client has both a nonqualified annuity and qualified retirement plans, it may make sense to receive the nonqualified annuity benefits first and delay starting receipt of the qualified benefits until a later time.



Yet another way in which annuities can be used in the income distribution process is as Individual Retirement Annuities used to receive rollovers or direct transfers from retirement plans.

Although a complete description of the IRA rules is beyond the scope of this course, it is helpful to realize that annuities can be used, as IRAs, to receive funds from qualified retirement plans. Typically, a qualified plan participant will have the option to make a direct transfer of his or her balance in the plan into either an IRA or another qualified plan.

Among other times, this option is often available when the person terminates employment or retires. Moving the funds to an IRA as part of an eligible rollover distribution will likely allow the individual to exercise a greater degree of control over how the funds are invested and how and when benefit payouts begin.



Other Retirement Planning Vehicles

To make the best use of the nonqualified annuity in retirement planning, one should understand alternate retirement planning techniques and grasp how these options interact with nonqualified annuities.

A brief discussion of the more commonly encountered types of retirement plans follows.


Individual Retirement Arrangements - An individual retirement arrangement, or IRA, is a similar planning tool to an annuity in many ways. Both are vehicles for tax-deferred savings.

However, an IRA contribution often results in an income tax deduction in the year the contribution is made. This deduction depends on income levels and on participation in other employer-provided plans.

And most IRA investments cannot offer a stream of payments that the owner cannot out live (unless, of course, the annuity is owned within an IRA).



IRA investments, other than annuities, may offer more or less liquidity than an annuity, and the investor must consider the impact of fees such as surrender charges and early withdrawal penalties.

For example, a mutual fund owned within an IRA may offer fairly rapid access to cash in case of an emergency, but require a sizable early withdrawal penalty. There are two ways to withdraw funds from many annuities: surrenders and loans. The availability and specific terms associated with these options vary between annuities, so careful scrutiny of available options is often called for.

In 1998, another form of IRA, the Roth IRA, became available. While contributions made to a Roth IRA are not tax deductible, funds distributed from a Roth IRA may be received completely free of any income tax, provided certain conditions are satisfied.



From a financial planning perspective, it is important to note that high-income taxpayers cannot take advantage of IRAs, making the use of a nonqualified annuity to accumulate funds for retirement purposes an attractive option.

While it is true that premiums paid into a nonqualified annuity are not income tax deductible and benefit payments from such an annuity will be partially taxable, there is no limit on the amount of funds that may be placed in a nonqualified annuity.

And, of course, the interest earned on the funds inside the annuity is tax deferred.



Qualified Retirement Plans - Generally, a qualified retirement plan is an employee benefit arrangement offered to employees by an employer. There are several different types of qualified plans, such as profit-sharing plans, 401(k) plans and employer stock ownership plans. A detailed explanation of these is beyond the scope of this course.

However, it is important to understand that while these plans are designed to provide an employee with some type of retirement benefit, most employees have little control over the type of plan offered by their employer or how the plan’s funds are invested. The nonqualified annuity offers a method of retirement planning over which the employee retains a much greater degree of control.



Most large corporations provide their employees with some type of qualified retirement plan. A few provide more than one plan.

However, many small companies and self-employed individuals do not have sufficient income to make contributions to such a plan.

Contributions to a nonqualified annuity by these individuals may provide their only source of retirement income other than government benefits such as Social Security.



Tax Sheltered Annuities - A tax sheltered annuity, or TSA, is a special type of annuity that is available only to individuals employed in public schools and nonprofit organizations that are operated exclusively for religious, literary, charitable, scientific, or educational purposes. Included here are churches, synagogues, hospitals, and colleges.

A TSA is usually issued by an insurance company. It may be either a fixed or a variable annuity contract.



Small Business Retirement Planning - For a self-employed individual, the use of a nonqualified annuity may provide the only source of retirement income, other than government benefits such as Social Security.

Many agents and financial planners find that a business owner who has just purchased an individual disability income policy is interested in beginning his retirement planning also.



Split Annuity Arrangement

One use of nonqualified annuities that has generated interest is called a “split annuity” or “combined annuity” arrangement.

Basically, with this arrangement an individual starts with a sum of money and then places a portion of the funds in an immediate annuity and the remainder of the funds in a deferred annuity.

The immediate annuity begins to pay out an income right away and typically is set up to continue to the payout for a set number of years.

The funds in the deferred annuity are not accessed during this period and remain in the deferred annuity.


Some versions of this arrangement suggest that at the end of the immediate annuity payout period, which may be somewhere between five and ten years, that the value of the deferred annuity may have increased to the point where the annuity holder can take a portion of the deferred annuity and purchase another immediate annuity that will pay a similar income for another set period of years.

Of course, whether this arrangement will work out as planned depends upon whether the rate of return assumed on the deferred annuity portion of the arrangement is met.

Split Annuity Arrangement


Annuities for Charitable Planning

There are occasions when an individual who has purchased an annuity finds that he would like to make a gift of either the contract itself or the funds held in the contract. There is no reason that an individual cannot make a gift of a nonqualified annuity contract, if that is his wish. However, there may be some unanticipated tax results.

An annuity holder who decides to surrender an annuity fully and make a gift of the funds must pay income tax on the amount received from the insurance company less his or her basis in the contract. Barring previous partial surrenders, the basis will likely be equal to the amount of premiums paid into the annuity. If the annuity holder is not at least age 59-½ at the time of the surrender, a 10% penalty tax on premature distributions may also apply.


After surrendering the annuity and paying the necessary taxes, the individual can make a gift of the cash received from the surrender. Generally, a gift of up to $10,000 per person as indexed ($11,000 in 2004) can be made before any gift tax will be due. In addition, an unlimited deduction from gift tax is generally available for gifts to charity.

The annuity holder could also simply make a gift of the annuity contract itself. This provides the person who receives the gift with the advantage of the income tax deferral on the interest earned inside the annuity. However, if the gift is of an annuity contract issued after April 22, 1987, the person making the gift is treated as having received an amount equal to the cash surrender value of the contract at the time of the gift minus the annuity holder’s investment.



Charitable Gift Annuity – As opposed to making a gift of an existing annuity, an individual can enter into a charitable gift annuity arrangement. There is no previously-purchased annuity contract in this instance.

Generally, a charitable gift annuity is an agreement between a charitable institution, such as a church or college, and an individual who wishes to make a contribution to the charity. If an individual donates property to the charity under a charitable gift annuity, he receives an annuity from the charity for the remainder of his life. There is no transfer of an annuity contract, rather the annuity payments are made directly from the charity to the individual and are backed by the charity’s assets and good name. The tax consequences of a charitable gift annuity can be complicated. There is usually an immediate income tax deduction for the person making the gift, although the amount of the deduction may be limited.



College Funding

Even before planning for their own retirement, the expense of providing their children with a college education is a primary concern for parents. The cost of a college education has increased rapidly in the last few years.

Currently, the cost to attend four years at a private college can well exceed $120,000 while the cost of four years at a state university can be upwards of $40,000.

In recent years, as annuity sales have increased rapidly, there has been much debate over the use of nonqualified annuities as a college-planning vehicle. In some instances, the annuity can be a useful tool. However, it is not always the best answer to the college-funding dilemma.


The major advantage in using an annuity for college planning is that the funds accumulate on a tax-deferred basis.

Since all the interest stays in the contract to accumulate even more interest, the tax-deferred annuity generally provides a greater rate of return than a financial vehicle that is taxed on a regular basis.

The primary drawback to using the annuity for college funding appears when it is time to take the funds out of the contract.

There are several ways that an annuity holder can withdraw funds from an annuity: These include a full surrender, a partial surrender, or annuitization of the contract.

College Funding


If the annuity holder decides on either a full or partial surrender, to withdraw the college funds, he will incur the 10% premature distribution penalty tax unless he is at least age 59-1/2.

By the time that the parent pays the regular income tax due on the surrender and then the penalty tax, the advantage gained by using the tax-deferred funding vehicle is often eliminated.

Of course, there is no requirement that the parent be the owner and annuitant of the annuity contract. One logical alternative that eliminates the age 59-1/2 problem is for a grandparent to be the owner and annuitant of the contract that will be used for funding a grandchild’s college education.

College Funding


Sale of a Business

Often, as a business owner approaches retirement age, he realizes that the only source of retirement income available will be Social Security. With the realization that he will not be able to quit working, the business owner often looks at selling all or part of the business to create funds for retirement.

If the business is sold, the former owner may find himself with a large amount of cash. Since the funds are intended to be used for retirement, a nonqualified annuity is often a good way to utilize the cash from the sale. Frequently, a business that was largely dependent on the talents of the owner will be sold for a smaller purchase price with former owner agreeing to serve as a consultant for several years and receive either a salary or percentage of the company’s sales or profits. In this situation, the former owner may wish to place the funds from the sale in a deferred annuity.


Consider the example of Mr. Jones who owns a successful insurance agency. As he approaches age 65, he agrees to sell the agency.

Since many of his large accounts are personal friends who may leave the agency without Mr. Jones in the business, the new owners may desire to keep Mr. Jones on staff for five years in exchange for a percentage of the commissions earned by the agency each year.

Mr. Jones agrees to a sale price of $500,000 which he places in a deferred annuity. He also places a percentage of his salary as he continues working into the deferred annuity.

At the end of five years when Mr. Jones is 70 years old and ready to completely retire, he annuitizes the contract and chooses to receive payments for the remainder of his life.

Sale of a Business


Bonus Plan

Occasionally an annuity is used in place of a life insurance policy in a type of nonqualified employee benefit plan referred to as a Bonus Plan or a Section 162 Bonus Plan. Although this type of plan is not a true “plan” it does provide a benefit. Under a Section 162 Bonus Plan, a corporation selects certain employees – usually top level executives – to receive a salary increase or bonus. This salary increase is deductible from income by the corporation under IRC Section 162 (hence the name) and must be included in income by the employee.

Once the increase is in the hands of the executive he uses it to pay the premium on a life insurance policy insuring his life and owned by him personally. Although a life insurance policy is usually used in this type of plan, an annuity may be substituted in certain instances such as when the executive cannot purchase insurance (i.e., is uninsurable) due to health problems.


Lesson 3Types of Annuities


Type According to When Benefits are Paid Out

When considering types of annuities according to when benefits are paid out, there are two primary types:

· Immediate annuity

· Deferred Annuity

An immediate annuity is one which begins paying benefits very quickly, usually within one year of the time it is purchased. By its nature, an immediate annuity is almost always purchased with a single premium.

The immediate annuity can be useful for an individual who has received a large sum of money and must count on these funds to pay expenses over a period of time.

Examples of this situation include life insurance proceeds and the funds received from the sale of a business or the completion of a large project.

Lesson 3: Types of Annuities

Consider the situation of Mrs. Black, age 62, who has just sold her consulting business for a lump sum payment of $75,000 plus a yearly percentage of the company’s income for the next three years.

Mrs. Black was divorced many years ago and will receive a small payment from her ex-husband’s pension plan. This payment, in addition to her Social Security benefits, will be her only retirement income since she did not have a retirement plan within her consulting company.

Purchasing a single premium immediate annuity with the $75,000 would provide Mrs. Black with a monthly income that she could not outlive, assuming she elected a settlement option based upon her life expectancy.



A deferred annuity, on the other hand, involves a delay in the receipt of benefit payouts until a future date – often timed to match the anticipated retirement date of the annuitant. The premium may be paid in a lump sum single payment or through periodic payments spread throughout the accumulation phases.

For example, Mr. Brown might purchase a deferred annuity at the age of 40 with the purpose of accumulating an amount of money over the next 25 years that would be used to supplement his retirement income. Mr. Brown can make monthly premium payments until a future date when he decides to begin receiving benefit payments.

Although his plan is to pay the premiums for 25 years, deferred annuities do offer a degree of flexibility that would allow him to modify his payments if his circumstances were to change.



Annuity Type Based on Premium Payment

When viewing annuities based on how and when premiums are paid, we are referring to single premium annuities and flexible premium annuities.

A single premium annuity is what its name implies: an annuity that is purchased with only one premium. This lone premium is usually fairly large. Many insurance companies have annuities designed to accept only the single premium payment and then begin paying benefits when the annuity holder elects to do so.

Many assume that annuities, and especially single premium annuities, are financial options designed only for the wealthy. This is not true. Many individuals who purchase a single premium annuity are not wealthy, but rather have received a large sum of money at one time. Since it is likely that these funds will be needed in the future to meet basic living expenses, the purchase of a single premium annuity often makes good financial sense.


Take the example of Mr. Green, age 62, who recently lost his wife. He has elected to receive the death proceeds of Mrs. Green’s group life insurance in a lump sum of $75,000. Mr. Green, who is self-employed and does not have any retirement plan for himself, plans to work for several more years.

He does not need these funds for current expenses, but he does want to use them to supplement his income after he retires.

If Mr. Green purchases a single premium annuity with the $75,000 he can elect to begin receiving benefits at his retirement age and, by electing a life income settlement option, he will have an income to supplement his Social Security benefits and Mrs. Green’s pension plan benefits that will continue throughout his lifetime.



The flexible premium annuity allows premium payments to be made at varying intervals and in varying amounts. This type of annuity is a useful tool for accumulating a sum of money at intervals and in amounts that cannot be predicted in advance.

For example, a flexible premium annuity contract might be purchased by Mrs. White to plan for her grandson’s college education. Since Mrs. White wishes to keep control over the funds she will be placing in the annuity, she names herself as the owner and the annuitant of the contract.

Over the next fifteen years, she will make a monthly deposit of a set amount into the annuity. Should she choose to do so, the annuity contract offers her the flexibility to make a larger monthly payment every so often.



Annuity Types Based on Investment Options

When considering annuities according to investment options offered, there are three primary types:

· Fixed annuities

· Variable annuities

· Indexed annuities

Fixed annuities are those with a “fixed” interest rate paid by the issuing insurance company on the funds in the annuity. When an individual purchases a fixed annuity, he or she knows what the current and guaranteed interest rates are.

Barring the insolvency of the insurance company, the investor also knows that these rates of interest will be credited to the funds in the annuity.


For example, if Ms. Brown purchases a flexible premium, fixed deferred annuity that is paying a current interest rate of 7%, Ms. Brown knows, without assuming any of the investment risk herself, that the insurance company will credit interest at a rate of 7% on the funds in her annuity until the date at which the current rate is altered.

This will be true whether or not the insurance company earns a sufficient rate of return on its own investments to support the current rate of 7%.



Another aspect of the fixed annuity that is “fixed” is the amount of the benefit that will be paid out of the annuity when the contract is annuitized.

When Ms. Brown, from our earlier example, decides to receive benefit payments from her annuity contract and selects the settlement option she desires, the amount of the check that she receives from the insurance company will be the same each month during the annuitization phase.

If she chooses a settlement option based on her life expectancy, she will receive the same amount each month for the rest of her life without any investment decisions or risk on her part.



Variable Annuity - With a variable annuity, the annuity holder receives varying rates of interest on the funds placed inside the annuity.

Depending upon the investment options chosen at the time of annuitization, the holder might receive benefit payments that vary in amount from month to month or from year to year.

In addition, the holder of a variable annuity assumes the risk associated with investment decisions that may not turn out as well as the investor hopes.



One major difference between fixed and variable annuities is that a variable annuity is considered to be a “security” under federal law, and is therefore subject to a greater degree of regulation. Anyone selling a variable annuity must have the required securities licenses.

Any potential buyer of a variable annuity must be provided a prospectus – a detailed document providing information on the variable annuity and the investment options available. With any sale of a variable annuity, the person making the sale must ascertain that the variable annuity is a suitable choice for the individual purchaser.

The assumption of risk by the holder of the annuity is a key element of the variable annuity; it is the product’s most distinguishing characteristic.



The annuity holder of a variable annuity determines which portion of premium payments, usually on a percentage basis, will be allocated to the different variable accounts.

Once this percentage is determined, it remains in effect until the annuity holder notifies the insurance company of a desire to alter the allocation arrangement.

Variable annuities also offer an annuity holder subaccount options in which to invest all or a portion of the annuity premiums. Typically, a variable annuity offers between seven and ten such variable accounts.

Unlike fixed annuities, it is the annuity holder who assumes the investment risk with variable annuities. To illustrate, assume that Mr. Mason is concerned that the return on his annuity premium dollars not be outpaced by the inflation rate over a period of time.



To combat this possibility, Mr. Mason decides to purchase a variable annuity, which offers investment choices of a guaranteed account, a stock fund emphasizing growth potential, a stock fund emphasizing income potential, a money market fund, and a bond fund.

With the inflation factor in mind, Mr. Mason allocated 75% of his premiums to the stock fund emphasizing growth potential and the remaining 25% to the variable annuity’s guaranteed fund.

On the funds in the guaranteed account, which functions similarly to a fixed annuity, Mr. Mason will receive the current interest rate of 6.5%.

On the funds in the stock fund, however, Mr. Mason has no guarantee from the insurance company or any other party that he will receive a certain rate of return. In fact, he has no guarantee that he will not lose part of the premium dollars that he has allocated to the variable investment account.



A typical variable annuity might offer the following investment options:

· Money Market Fund;

· Government Securities Fund;

· Bond Fund;

· Total Return (or Balanced) Fund;

· Growth (or Common Stock) Fund;

· Growth with Income (Stock) Fund; and

· Guaranteed Account.



Although an annuity purchaser could allocate one-seventh of the premium dollars to each of these options, in reality the investment strategy should be tailored to specific financial goals.

For example, if Mr. Smith wants to invest his annuity premiums in such a way as to minimize the bite that inflation will take out of his financial capability over a period of years, Mr. Smith would be wise to invest a sizable portion of his premium dollars in the Growth Fund with smaller portions going into the Total Return Fund and, perhaps, the Guaranteed Account.

The actual percentage allocations should be chosen according to Mr. Smith’s age and tolerance for risk.



On the other hand, Mr. And Mrs. Jones will retire in about five years. They have accumulated a sizable amount in a variable annuity that they have owned for a decade.

At this point in their lives, preserving the capital they have accumulated is probably of greater importance to them than taking any large degree of risk.

Repositioning their funds in the Guaranteed Fund and the Money Market Fund would provide an investment approach they would feel comfortable with.

The variable annuity’s ability to offer varying mixes of investment options that are appropriate at different points in the annuity holder’s life is one of its most attractive features.



An equity-indexed annuity credits earnings based on the movement in an equity index, yet guarantees a certain minimum return.

In other words, an equity-indexed annuity allows the holder to participate in stock market gains without risking severe losses when the market declines.

In a financial environment where interest rates on fixed annuities are relatively low, this ability to share in stock market gains while limiting potential loss clearly appeals to prospective annuity buyers.



One of the disadvantages of the equity-indexed annuity is that because of its link to the equity index, it is considerably more complex than the “plain vanilla” fixed annuity.

Also, different life insurance companies calculate the rate payable on their equity-indexed annuities in diverse ways.

In fact, there is quite a bit of difference on this point with various crediting methods that are used, such as the high water mark method, the point-to-point method, and the annual reset (or ratchet) method.

The indexing methods used and standard contracts associated with EIAs are different from the more traditional fixed and variable annuity contracts.



Lesson 4Parties to an Annuity


Parties to an Annuity

An annuity is a legal contract in which certain parties have certain rights and responsibilities to each other. It is important to understand who the parties to the contract are, and to be familiar with the general rights and obligations of each party.

Typically, there are four potential parties to a nonqualified annuity contract:

1. owner – person who purchases the annuity

2. annuitant – individual whose life is used in determining how payments will be made

3. beneficiary – individual or entity that will receive any deaths benefits

4. issuing insurance company – organization that accepts the owner’s premium and promises to pay the benefits spelled out in the contract

Lesson 4: Parties to an Annuity

Although there are four potential parties to each annuity contract, the most common situation involves only three parties, because the owner and the annuitant are usually the same individual.

As an example of this commonly used arrangement, consider Ms. Jackson. She has just attended her youngest child’s college graduation ceremony, and is now turning her attention to seriously planning for her retirement years.

Her insurance agent gives her a tip: she can purchase a nonqualified deferred annuity from an insurance company, placing $200 each month into the annuity.

When she retires, the contract will move from the accumulation phase to the payout phase, and will begin providing her with a monthly benefit.



In setting up the annuity, Ms. Jackson will be named as both the contract owner and the annuitant. She will name a beneficiary for any death benefits that are paid from the contract should she die before reaching retirement age. Most likely, Ms. Jackson will name one of her children as the beneficiary. The third party, the insurance company, will be the party from which Ms. Jackson purchases the annuity.

The agent is technically not a separate party to the annuity contract, but is instead a representative of the insurance company. However, he or she has many important responsibilities to the other parties. While these responsibilities can be considered part of the duties and obligations of the insurer, they are best considered separately.

We will examine the rights and responsibilities of each of the parties to an annuity in detail.



The Owner

Every annuity contract has an owner. This party is referred to as either the owner, the annuity holder, or the annuity owner. With a nonqualified annuity contract, the owner is usually a real person, someone who has decided to purchase the annuity as part of a financial plan for retirement or for some other purpose.

But there is no requirement that the owner be a real person. An annuity contract might be owned by various types of trusts, or by a business that is organized as a corporation or a partnership.

In the most common instance, where the owner and the annuitant are the same person, the owner pays premiums into the annuity during the accumulation phase. At the end of this phase, the owner-annuitant begins to receive the annuity benefit payments from the insurance company.


As the term “owner” implies, the owner of the annuity contract holds a number of rights under the contract. The owner decides who will serve as the annuitant and who will be the beneficiary under the contract. Also, it is the owner who determines when the annuity contract will move from the accumulation phase into the annuitization phase and begin to pay benefits. If Ms. Gulden purchased a single premium annuity twenty years ago, as owner of the annuity contract, she can choose to begin receiving annuity payments today, or she can wait until some point in the future. Most annuity contracts do specify a maximum age past which annuity payouts cannot be deferred, but in most contracts this age is well past the usual retirement age.

Under a typical annuity contract, Ms. Gulden also has the right to make a partial surrender and receive a portion of the funds accumulated inside the contract. She can also choose to end the contract completely by fully surrendering the contract.

The Owner


To illustrate Ms. Gulden’s options in this respect, assume that the contract value today is $50,000. As owner of the contract, Ms. Gulden may make a partial surrender of an amount less than the full $50,000 value.

If she chooses to receive $20,000 from the contract, the annuity contract will continue in force but with a value of only $30,000. When she chooses to begin receiving the annuity benefit payments, she will be entitled to benefits calculated on the remaining $30,000 value in the contract.

As owner of the contract, Ms. Gulden can also choose to fully surrender the contract, receiving the entire $50,000 value today.

Should she decide to do this, the annuity contract will be at an end, and neither Ms. Gulden nor the insurance company will have any further rights or obligations relating to the annuity.

The Owner


The Annuitant

The annuitant is the individual whose life serves as the measuring stick to determine benefits paid out under the contract.

According to the Internal Revenue Code, the annuitant is the individual whose life is of primary importance in affecting the timing or amount of the payout under the contract. In other words, the annuitant’s life is the measuring life. Thus, the annuitant, unlike the owner or the beneficiary of the annuity contract, must be a real flesh-and-blood person.

Although it is the most common arrangement, there is no requirement that the owner of the annuity contract and the annuitant be the same individual.

For example, a father, age 50, buys an annuity contract and is the owner. He names his son, age 25, as the annuitant, with annuity payments to begin when his son reaches age 45.


When the accumulation phase of the annuity draws to a close and the owner wishes to annuitize the contract and begin receiving annuity benefit payments, the life expectancy of the annuitant can come into play. The method by which benefits are paid depends upon which annuity payout or settlement option is elected.

For example, if Mr. Laurie is both the owner and annuitant of a contract that will begin paying benefits when he is age 65, and he elects a life only payout option, the fact that Mr. Laurie has a life expectancy of 20 years will be used in calculating the portion of the benefit payout that will be taxed to him.

For income tax purposes, the 20 year life expectancy figure is taken from the applicable annuity table issued by the Internal Revenue Service.

The Annuitant


In addition, a similar life expectancy figure will be used by the insurance company that sold the annuity to Mr. Laurie in calculating the amount of his monthly annuity benefit. Thus, the annuitant’s age (and therefore his or her life expectancy) at the time the benefit payout begins will affect this monthly benefit amount.

Consider the example of three owner-annuitants who each hold contracts with an accumulation value of $50,000. Mr. Gray is 65 years old; if he decides to begin receiving annuity benefits now, his benefit will be about $334 per month under a life only settlement option.

Mr. Davis is 75; if he begins to receive benefits from his $50,000 annuity, his monthly payout amount under a life only settlement option will be about $471 per month. Mr. Tarvin, who retires early, annuitizing his contract at 55, will receive only $265 per month.

The Annuitant


The Beneficiary

Similar to the beneficiary of a life insurance policy, the beneficiary of an annuity contract receives a death benefit when another party to the contract dies prior to the time of annuitization.

The death benefit payment allows an owner to recover his investment and pass it along to his beneficiary if he does not live long enough to begin receiving annuity contract benefits. The death benefit amount is equal generally to the value of the annuity contract at the time of death.

There is no requirement that the beneficiary be a flesh-and-blood individual. Often, a trust or other entity-such as a charitable organization-is named as the annuity contract beneficiary.


As an example, assume that Mrs. Smith purchased an annuity, naming herself as both owner and annuitant, and naming her nephew, her only living relative, as the beneficiary.

Mrs. Smith purchased this deferred annuity contract when she was 50 years old, and she does not plan to annuitize it (that is, to begin receiving benefits) until she retires at age 65.

If she dies prior to retirement, the typical annuity contract will pay a death benefit to her nephew approximately equal to the premiums that Mrs. Smith paid into the annuity, plus the interest earned on those premiums.

The Beneficiary


But if Mrs. Smith survives until she retires at age 65, begins receiving annuity benefits under a life only income option, and then dies at age 67, there will be no death benefit payable to the beneficiary or any other party.

This will be true even though Mrs. Smith had not received anywhere close to the amount of premiums she paid into the annuity in two years of benefit payments.

Had Mrs. Smith elected a method of benefit payout that offered a refund or a guarantee instead of the life only income option, some benefit payments have been available to her nephew.

Most annuity contracts offer a variety of benefit payout or settlement options.

The Beneficiary


Payment of the death benefit at the death of an owner or annuitant is altered somewhat when there is a surviving spouse that has been named as the beneficiary under the contract. The Internal Revenue Code allows a surviving spouse to “step into the shoes” of the deceased person. In effect, the surviving spouse becomes the new owner of the annuity and is permitted to continue the annuity contract without change.

For example, assume that Mr. Jones purchased a single premium deferred annuity five years prior to his death, naming himself as owner and annuitant and his wife, Mrs. Jones, as the designated beneficiary. He had not yet started to receive payments from the annuity contract at his death. Mrs. Jones, as the designated beneficiary, would be treated as the annuity contract owner, and would be allowed to continue the annuity in its accumulation phase for the time being.

The Beneficiary


Mrs. Jones would then have the ability to change the payout settlement option of the contract as the new owner, and would also have the right to request a full or partial surrender of the contract.

The beneficiary has no rights under the annuity contract, other than the right to receive payment of the death benefit.

The beneficiary cannot change the payout settlement option, alter the starting date for benefit payments, or make any withdrawals or partial surrenders against the contract.

The owner has the sole right, under most contracts, to change the beneficiary designation at any time.

The Beneficiary


SB 483 and Beneficiaries

SB 483 is a law passed in 2008 which limits how much equity individuals can have in their principal residence to receive medical assistance through the Medi-Cal program.

If an individual’s home equity exceeds $750,000, an applicant is disqualified from Medi-Cal services.

SB 483 increases the look back period from 30 months to 60 months in regards to transfer of assets. Also, rather than being penalized for transfer of assets on the date of the transfer, SB 483 applies this penalty on the date of application for services.


The Insurance Company

The insurance company issues the annuity contract and, in doing so, assumes a number of financial obligations to the owner, the annuitant, and the beneficiary.

In a very general sense, the insurance company that issues an annuity contract promises to invest the owner’s premium payments responsibly and credit interest to the funds placed in the annuity.

How the premium payments are invested and how much control the owner retains over the investment decisions, if any, varies depending upon which type of annuity is purchased.

The insurance company also promises to pay the contract death benefit in the event of the death of the owner prior to annuitization and to make benefit payouts according to the contract settlement option.


Annuity contracts differ from one company to the next. The Internal Revenue Code requires that all annuities contain certain provisions in order to be eligible for the tax benefits associated with the annuity contract, but much room remains for variation between companies.

The best source of information on the specific provisions of an annuity contract is, of course, the issuing insurance company itself.

Many agents and financial planners request a sample contract for each of the annuity products they work with to enhance their understanding of each contract.



The purchaser of an annuity contract should be knowledgeable about and comfortable with the financial strength and investment philosophy of the company that is issuing the contract.

While the California Guarantee Fund is designed to provide relief for annuity and insurance policy holders of firms that go out of business, there is no guarantee that such individuals will receive full value of their claim. Several ratings agencies are available to help evaluate a particular company’s financial strength.

These services are often used by agents, financial planners, and consumers. Well known rating services include those from the A.M. Best Company, Moody’s, Standard & Poor’s, and Fitch. Ratings take into account a company’s investment strategy, marketing philosophy, profitability, and history.



One key area of financial stability involves the funds insurers set aside, or reserve, in order to pay benefits and surrenders.

When an annuity is purchased, the insurance company, by law, must set aside over one dollar for every dollar deposited in an annuity contract in reserves.

While funds held in reserve in excess of the required amount can be used to pay benefits or surrenders, they cannot be used to settle claims, expenses or bad debts, or be used for non-related benefit payments.

Reserves are managed as a separate fund from the insurer’s other invested funds, and there are rules as to how the reserve funds can be managed which generally require that they are invested conservatively.



The amount of excess reserves is a valuable indicator of a firm’s ability to continue selling Annuities at prevailing terms and rates, and how well the company matches investment and asset to liability.

Consumers should recognize that companies with high excess reserve ratios are in a strong financial position compared to firms with low ratios.

It is especially important to consider excess reserve ratios in periods of low interest rates, which places additional pressure on insurers to maintain investment performance at a sufficient rate to maintain the excess reserve ratio.

Of course, the insurance company must observe current regulations regarding the advertising and marketing of annuity products. Some of the most important California-specific regulations are described next.



Advertising

Per Section 787 of the CIC, any advertisement or other device designed to produce leads based on a response from a potential insured which is directed towards persons age 65 or older shall prominently disclose that an agent may contact the applicant if that is the fact.

In addition, an agent who makes contact with a person as a result of acquiring that person's name from a lead generating device shall disclose that fact in the initial contact with the person.


No insurer, agent, broker, solicitor, or other person or other entity shall solicit persons age 65 and older in this state for the purchase of disability insurance, life insurance, or annuities through the use of a true or fictitious name which is deceptive or misleading with regard to the status, character, or proprietary or representative capacity of the entity or person, or to the true purpose of the advertisement.

An advertisement includes envelopes, stationery, business cards, or other materials designed to describe and encourage the purchase of a policy or certificate of disability insurance, life insurance, or an annuity.

Advertising


Advertisements shall not employ words, letters, initials, symbols, or other devices which are so similar to those used by governmental agencies, a nonprofit or charitable institution, senior organization, or other insurer that they could have the capacity or tendency to mislead the public. Examples of misleading materials, include, but are not limited to, those which imply any of the following:

1. The advertised coverages are somehow provided by or are endorsed by any governmental agencies, nonprofit or charitable institution or senior organizations.

2. The advertiser is the same as, is connected with, or is endorsed by governmental agencies, nonprofit or charitable institutions or senior organizations.

Advertising


No advertisement may use the name of a state or political subdivision thereof in a policy name or description.

No advertisement may use any name, service mark, slogan, symbol, or any device in any manner that implies that the insurer, or the policy or certificate advertised, or that any agency who may call upon the consumer in response to the advertisement, is connected with a governmental agency, such as the Social Security Administration.

No advertisement may imply that the reader may lose a right, or privilege, or benefits under federal, state, or local law if he or she fails to respond to the advertisement.

An insurer, agent, broker, or other entity may not use an address so as to mislead or deceive as to the true identity, location, or licensing status of the insurer, agent, broker, or other entity.

Advertising


No insurer may use, in the trade name of its insurance policy or certificate, any terminology or words so similar to the name of a governmental agency or governmental program as to have the capacity or the tendency to confuse, deceive, or mislead a prospective purchaser.

All advertisements used by agents, producers, brokers, solicitors, or other persons for a policy of an insurer shall have written approval of the insurer before they may be used.

No insurer, agent, broker, or other entity may solicit a particular class by use of advertisements which state or imply that the occupational or other status as members of the class entitles them to reduced rates on a group or other basis when, in fact, the policy or certificate being advertised is sold on an individual basis at regular rates.

Advertising


In addition to any other prohibition on untrue, deceptive, or misleading advertisements, no advertisement for an event where insurance products will be offered for sale may use the terms “seminar,” “class,” “informational meeting,” or substantially equivalent terms to characterize the purpose of the public gathering or event unless it adds the words “and insurance sales presentation” immediately following those terms in the same type size and font as those terms.

Advertising


Replacement Policies

Section 10509.6 of the CIC stipulates detailed regulations for insurers and agents who represent the sale of a policy or contract as a replacement for one that is currently in force.

Agents must provide a signed statement as to whether replacement is or may be involved in an annuity transaction.

Where a replacement is involved, the agent must provide:

1. A list of the applicant’s existing life insurance or annuities being replaced, and

2. A copy of the replacement notice provided to the applicant identifying existing policies or certificates by name of the insurer, insured, and contract number or alternative identification, such as an application or receipt number.


Within three business days of receipt of the agent’s notification or proposed issue date (whichever is sooner), the insurer must send written communication to each existing life insurer advising of the proposed replacement and the identification information, policy summary, contract summary, or ledger statement containing policy data on the proposed life insurance or annuity.

Cost indices and equivalent level annual dividend figures are not required.

Within 20 days from the date the written communication is received by the existing insurer(s), the agent (or insurer) must furnish the policy owner a policy summary for the existing life insurance or ledger statement containing policy data on the existing policy or annuity.



Cost indices and equivalent level annual dividend figures need not be included.

When annuities are involved, the disclosure information shall be that in the contract summary.

The replacing insurer may request the existing insurer to furnish it with a copy of the summaries or ledger statement, which must be provided within five working days of the receipt of the request.

The replacing insurer must maintain for three years evidence of the “notice regarding replacement,” the policy summary, the contract summary, and any ledger statements used, ledger statements, and a replacement register, cross-indexed by replacing agent and existing insurer to be replaced.



Policy Cancellations and Refunds

Section 10127.10 of the California Insurance Code establishes regulations concerning policy cancellations and refunds.

These rules state that all certificates issued or delivered to individuals age 60 or older in California must provide an examination period of at least 30 days after the receipt of the policy or certificate for purposes of review of the contract, during which time the applicant may return the policy to the insurer by mail or otherwise, voiding the certificate from the beginning, leaving the parties as if no contract had been issued. This 30 day period is known as a “Free Look Period.”

All premiums or policy fees already paid must be fully reimbursed by the insurer within 30 days of policy cancellation. Insurers are liable for interest in addition to premiums if refunds are not made on a timely basis.


Cancellation of Variable Annuities – Most variable annuity contracts will not allow the investment of annuity funds into variable accounts until after the 30-day free look period has expired. However, if the owner directed that the premium be invested in the mutual funds immediately, the owner would receive the actual account value in case of cancellation.

· If the owner had not directed that the premium be invested in mutual funds underlying the contract during the cancellation period, then returning the policy during the review period must effectively void the policy, leaving both parties in the same position as if no policy had been issued. Any premiums and policy fees paid must be refunded to the owner within 30 days from the date of cancellation notification.

· If the owner had directed that the premium be invested in mutual funds underlying the contract during the review period, in case of cancellation the owner must receive a refund of the account value within 30 days of cancellation notification.

All annuity contracts delivered or issued for delivery to senior citizens in California must include a cancellation notice printed on or attached to the contract stating the cancellation terms.



Cancellation Notice for Fixed Annuities - Every individual life insurance policy and annuity contract (except variable contracts and modified guaranteed contracts) delivered or issued for delivery in California must have the following notice printed on either the cover page or policy jacket in 12-point bold print, with one inch of space on all sides or printed on a sticker that is affixed to the cover page or policy jacket.

The phrase “after 30 days, cancellation may result in a substantial penalty, known as a surrender charge” is required only if such charges or penalties apply.



Cancellation Notice for Variable Annuities - Variable annuity contracts, variable life insurance contracts, and modified guaranteed contracts delivered or issued for delivery in California must have the following notice either printed on the cover page or policy jacket in 12-point bold print with one inch of space on all sides or printed on a sticker that is affixed to the cover page or policy jacket.

The words “known as a surrender charge” are required only if such charges apply.



Lesson 5Contract Provisions and How They

Affect Consumers


Common Contract Provisions

While all annuity contracts are not the same, there are certain standard provisions common to most traditional annuities.

The Internal Revenue Code and California Insurance Code both govern the provisions which must be included in traditional annuity contracts sold within the state of California.

We will first review contract provisions that are typically common to all annuities.

Lesson 5: Contract Provisions and Consumers

Issue Ages and Maximum Issue Age

A maximum issue age is the age at which an insurance company will sell an annuity to an individual. Some companies specify a maximum issue age while others don’t.

There is no minimum age at which an individual can participate in an annuity contract as an annuitant, beneficiary or owner.

However, in the state of California parents must provide written consent for the purchase of annuities naming minors under the age of 16 as beneficiary, owner or annuitant, as well as for any exercise of contractual rights.


Maximum Ages for Benefits to Begin

Under the Internal Revenue Code, there is no age at which distributions or benefit payments must begin for nonqualified annuities.

However, most insurance companies specify a maximum age at which the annuity holder must begin receiving benefit payouts from the annuity. Like other annuity provisions, this maximum age varies, and indeed, in recent years, has generally been set at increasingly advanced ages. Many contracts require payout to begin when the annuitant reaches age 80 or 85.

The Internal Revenue Code does set a minimum age for benefits to begin to be paid out of certain types of annuities. Generally, these are annuities into which the funds were placed either by an individual’s employer through a qualified or individual retirement plan. Rules for minimum distributions and the age at which they must begin are complex for these types of plans.


Premium Payments

Most annuity contracts require that each premium payment be at least a certain minimum amount – primarily to make the administration of the contract easier. The required minimum amount varies widely from one annuity to another.

For example, one nonqualified deferred annuity might require a minimum monthly premium of only $50, while another nonqualified annuity might require a minimum initial single premium of $25,000 with subsequent payments subject to a minimum of $50.

Often, an insurance company will offer several versions of one annuity contract with varying minimum premium requirements.

Usually, the higher the required minimum premium, the more likely the annuity is to offer a greater number of investment options, free transfers among variable accounts, and certain interest rate bonuses.


Because premium payments are continued at the election of the annuity contract holder, he or she may choose to skip a payment, to increase or decrease the amount of the premium, or to discontinue premium payments altogether.

Of course, any decrease in or discontinuance of the planned premium will adversely affect any accumulation amounts projected for future planning purposes.

Usually, the buyer of an annuity chooses how often to make premium payments. Most annuity contracts will accept premiums annually, quarterly or monthly.

Many insurance companies will arrange for the funds to be transferred directly out of the annuity owners’ bank account.

Premium Payments


Advance Payments

An incorporated life insurer issuing life insurance policies on the reserve basis may collect premiums in advance. Insurers may also accept moneys for the payment of future premiums related to any policies issued by it.

No such insurer may accept such moneys in an amount to exceed (1) the sum of future unpaid premiums on any such policy or (2) the sum of 10 such future unpaid annual premiums on any such policy if such sum is less than the sum of future unpaid premiums on any such policy.

Insurers’ rights to accept funds under an agreement which provides for an accumulation of such funds for the purpose of purchasing annuities at future dates cannot legally be limited.


Surrender Charges

Most annuity contracts levy a “charge” against partial and full surrenders from the contract for a period of years after the annuity is purchased.

This charge, usually referred to as a “surrender charge” or “deferred sales charge” is intended com make it less appealing for annuity owners to move funds in and out of annuities. It also provides a means for the insurance company to recover its costs if the contract does not remain in force over the intended longer term.

The surrender charge is usually applicable to surrenders made from the annuity for a certain number of years. Although this period varies from one annuity to another, it typically runs from five to ten years although it’s becoming more common to see surrender charge periods up to twenty years.


The surrender charge is generally a percentage that is applied to the funds received as a result of the surrender. Typically, the surrender charge percentage decreases with each passing year.

If a Section 1035 exchange is being contemplated, it is important to keep in mind the fact that the contract surrender charge is no longer applicable to a specific annuity contract.

Although, Internal Revenue Code Section 1035 will prevent current income taxation on the exchange of one annuity for another, generally the newly-received annuity contract will be subject to contract surrender charges for several years after the exchange.

However, if the Section 1035 exchange does not take place, the original annuity contract will still be in force and will not be subject to any contract surrender charges.

Surrender Charges


To illustrate in greater detail, assume that Mr. Smith makes a partial surrender of $10,000 from his annuity in a year in which the surrender charge is 5%. He will lose $500 (5% of $10,000) as a result of the surrender, effectively receiving only $9,500. Some insurance companies subtract the amount of the surrender charge from the amount actually paid to the contract holder, as illustrated with Mr. Smith.

Other annuity contracts provide that, with a partial surrender, the surrender charge is applied against the values still remaining in the contract after the surrender.

Thus, in this instance, Mr. Smith would receive a check for the full $10,000 partial surrender amount but a $500 charge would be levied against the funds remaining in his annuity. In the event of a full surrender, of course, the check sent to Mr. Smith would be reduced by the amount of the surrender charge.

Surrender Charges


Some companies apply the surrender charge percentage against the full amount surrendered and, after a specified number of years have passed, no surrender charge is applicable regardless of when premiums have been paid into the annuity.

However, other companies use a method of applying the surrender charge percentage that is a bit more complicated. The provision in an annuity contract in this instance might provide that the percentage will be applied only against premiums paid in.

Premiums are considered to be taken out of the annuity on the basis that the first premiums paid in are the first taken out.

Surrender Charges


Thus, if a contract had been in force for five years with a premium payment made each year when the contract holder decided to fully surrender the contract, an amount of the surrender equal to the premium paid in the first year would be subject to the surrender charge applicable in the fifth contract year, an amount equal to the second year’s premium would be subject to the fourth contract year’s percentage charge, and so on.

Any premium that remains in the contract for five years before a surrender takes place is not subject to any surrender charge.

Many annuity contracts provide that no surrender charge will be levied if the annuitant dies or becomes disabled.

Surrender Charges


Having looked at how surrender charges are assessed under the annuity contract, it bears restating that this surrender charge is one that originates in the annuity contract itself.

This “contract” surrender charge should not be confused with the 10% penalty tax that is applicable to premature withdrawals from annuities under the Internal Revenue Code. These two “penalties” or “charges” are often confused. This confusion is easy to understand because it is possible for a surrender from an annuity to be subject to both or only one of the contract surrender charge and the 10% penalty tax.

It is also possible that a surrender of funds from an annuity will not be subject to either of these items as the penalty tax generally applies to distributions received prior to age 59½ and the contract surrender charges apply during the first few years after the annuity is purchased.

Surrender Charges


To illustrate, assume that Mr. Smith, age 65, purchased a deferred annuity two years ago.

If he surrenders the contract this year, he will incur the third year contract surrender charge of 6% but he will not be subject to the Internal Revenue Code 10% penalty tax because he is older than age 59½ at the time of the surrender.

However, if Ms. Jones, age 44, surrenders a deferred annuity contract purchased 20 years ago, it is not likely that any contract surrender charges will still be applicable, but the Internal Revenue Code’s 10% penalty will still apply because Ms. Jones is younger than age 59½ .

Surrender Charges


Surrender Charge Waivers

Some annuity contracts offer a waiver of the annuity contract’s surrender charges in the event that the annuitant is either hospitalized or confined to a nursing home for a certain period of time, such as 30 days.

This “Nursing Home Waiver” provision allows the owner of the contract to extract funds from the annuity contract that might be needed to meet the expenses or lost income associated with the hospitalization or confinement.

Other annuity contracts allow medically-related surrenders that are not subject to the contract’s surrender charges.

Generally, there is a requirement that the annuitant be confined in a medical care facility for a certain period of time or be diagnosed with a terminal illness.


Although not part of the annuity contract, the 10% premature distribution penalty tax may be applicable to a withdrawal made for this reason if the taxpayer is under age 59½ .

To avoid the imposition of this tax penalty, the taxpayer must be able to qualify as being “disabled” as that term is defined in the Internal Revenue Code.

The Code’s definition may differ from the definition used in the annuity contract. In the Internal Revenue Code, for purposes of the 10% premature distribution penalty tax, “disabled” is defined as being “… unable to engage in any substantial gainful activity by reason of any medically determinable physical or mental impairment which can be expected to result in death or to be of long-continued and indefinite duration.”

Similar waivers are available for terminal illness, unemployment, and disability.

Surrender Charge Waivers


Surrender Charges and Senior Citizens

Whenever an insurer provides an annual statement to a senior citizen policy owner of an individual life insurance policy or an individual annuity contract issued after January 1, 1995, the insurer shall also provide the current accumulation value and the current cash surrender value.


Required Notices and Printing Requirements

Every individual life insurance policy and every individual annuity contract, other than variable contracts and modified guaranteed contracts, subject to this section, that is delivered or issued for delivery in this state shall have the following notice either printed on the cover page or policy jacket in 12-point bold print with one inch of space on all sides or printed on a sticker that is affixed to the cover page or policy jacket:

IMPORTANT

YOU HAVE PURCHASED A LIFE INSURANCE POLICY OR ANNUITY CONTRACT. CAREFULLY REVIEW IT FOR LIMITATIONS.

THIS POLICY MAY BE RETURNED WITHIN 30 DAYS FROM THE DATE YOU RECEIVED IT FOR A FULL REFUND BY RETURNING IT TO THE INSURANCE COMPANY OR AGENT WHO SOLD YOU THIS POLICY. AFTER 30 DAYS, CANCELLATION MAY RESULT IN A SUBSTANTIAL PENALTY, KNOWN AS A SURRENDER CHARGE.


The phrase "after 30 days, cancellation may result in a substantial penalty, known as a surrender charge" may be deleted if the policy does not contain those charges or penalties.

Every individual variable annuity contract, variable life insurance contract, or modified guaranteed contract subject to this section, that is delivered or issued for delivery in this state, shall have the following notice either printed on the cover page or policy jacket in 12-point bold print with one inch of space on all sides or printed on a sticker that is affixed to the cover page or policy jacket:

IMPORTANT

YOU HAVE PURCHASED A VARIABLE ANNUITY CONTRACT (VARIABLE LIFE INSURANCE CONTRACT, OR MODIFIED GUARANTEED CONTRACT).

CAREFULLY REVIEW IT FOR LIMITATIONS.



THIS POLICY MAY BE RETURNED WITHIN 30 DAYS FROM THE DATE YOU RECEIVED IT. DURING THAT 30-DAY PERIOD, YOUR MONEY WILL BE PLACED IN A FIXED ACCOUNT OR MONEY-MARKET FUND, UNLESS YOU DIRECT THAT THE PREMIUM BE INVESTED IN A STOCK OR BOND PORTFOLIO UNDERLYING THE CONTRACT DURING THE 30-DAY PERIOD. IF YOU DO NOT DIRECT THAT THE PREMIUM BE INVESTED IN A STOCK OR BOND PORTFOLIO, AND IF YOU RETURN THE POLICY WITHIN THE 30-DAY PERIOD, YOU WILL BE ENTITLED TO A REFUND OF THE PREMIUM AND POLICY FEES. IF YOU DIRECT THAT THE PREMIUM BE INVESTED IN A STOCK OR BOND PORTFOLIO DURING THE 30-DAY PERIOD, AND IF YOU RETURN THE POLICY DURING THAT PERIOD, YOU WILL BE ENTITLED TO A REFUND OF THE POLICY'S ACCOUNT VALUE ON THE DAY THE POLICY IS RECEIVED BY THE INSURANCE COMPANY OR AGENT WHO SOLD YOU THIS POLICY, WHICH COULD BE LESS THAN THE PREMIUM YOU PAID FOR THE POLICY. A RETURN OF THE POLICY AFTER 30 DAYS MAY RESULT IN A SUBSTANTIAL PENALTY, KNOWN AS A SURRENDER CHARGE.



Market Value Adjustments

A market value adjustment (MVA) can be assessed on surrenders and withdrawals to compensate the insurer for the risk that annuity owners will withdraw funds at a time when the market value of the investments backing the annuity is low.


Administration Charges and Fees

In addition to interest rates and crediting methods, buyers must also be aware of fees and charges that can apply to annuities, especially administrative fees and surrender charges.

Administration fees are levied to cover the set-up of the annuity, preparing statements, maintaining online access, changing beneficiaries and other miscellaneous insurer activities. At one time, it was common practice to charge a front-end sales fee or front-end load on fixed annuities.

However, this was so unpopular with buyers that the practice has largely been abolished. In general, administrative fees are lower on fixed annuities than on variable annuities because insurers can set the current interest rate lower than their expected return in order to cover miscellaneous administrative expenses.


Withdrawal Options

Annuity contracts generally offer several options for making withdrawals from annuities.

Partial Surrender – Almost all nonqualified annuity contracts permit the contract holder to make a surrender of a portion of the values accumulated in the annuity prior to the time that the annuity begins paying benefits. Some contracts limit the frequency with which partial surrenders may be made and some require that a minimum amount remain in the annuity after any surrender is made.


For example, an annuity might allow only one partial surrender each contract year and might require that at least $5,000 remain after such a surrender. Some annuities require that the amount of the partial surrender be at least a certain minimum amount such as $100 or $500.

Some annuity contracts will waive the contract surrender charge for a certain number of partial surrenders from the contract. A common number here is one per contract year. Other contracts permit a percentage of the value, such as 10%, to be surrendered or withdrawn each year free of surrender charge.

Remember that even though the insurance company does not assess a surrender charge under the annuity contract, the 10% premature distribution penalty tax assessed under the Internal Revenue Code may still be applicable.

Withdrawal Options


Full Surrender – An annuity can be surrendered in full at any time prior to the time it is annuitized and begins to make benefit payments.

In addition to the income tax ramifications, contract surrender charges and income tax penalty taxes may be applicable.

After a full surrender, the annuity contract is no longer in existence and, of course, will not pay any benefits to the annuitant, owner, or beneficiary.

Withdrawal Options


10% Per Year Withdrawal – Many annuities allow the contract holder to withdraw or make a partial surrender of an amount equal to 10% of the accumulation value each contract year without the contract surrender charges being applied.

Usually this feature is not available until the second contract year. With some annuity contracts, this 10% is cumulative or, in other words, can be carried over from one contract year and added to the next year’s 10% amount.

For example, if an annuity holder makes a 10% surrender in the second year of the contract and then does not make any surrender in the third contract year, in the fourth contract year the annuity holder would be able to surrender as much as 20% of the annuity’s accumulation value without paying the contract surrender charges. Usually, there is a maximum amount, such as 50%, that may be accumulated.

Withdrawal Options


Systematic Withdrawal Option – Many annuity contracts offer the contract holder a systematic withdrawal option as a way to take money out of the annuity contract during the accumulation phase.

The annuity holder can elect to withdraw a set amount each month or each year without any contract fee or surrender charge assessed.

Usually, the contract holder can terminate or alter the systematic withdrawal option at any time.

Under some annuity contracts, the annuity holder can make lump sum withdrawals from the annuity in addition to the withdrawals made under the systematic withdrawal option.

Withdrawal Options


Income Distributions

Income is distributed during the “annuitization phase, which is also commonly referred to as the payout period, benefit period, or distribution phase. This is the “taking out” phase – when money is taken out of policy, either through withdrawals or annuitization. The annuitization phase varies by the type of annuity and can last for a set number of months or years, or the lifetime of the annuitant as defined in the annuity contract.

It’s important to understand the difference between the annuity contract’s “required” annuitization date (the date by which benefit payments must begin) and the annuity’s “permitted” annuitization date – or the date upon which the annuitant can elect to begin receiving payouts. Many annuity owners will prefer a late maturity date that allows them to stay in the accumulation phase as long as possible, while having the option to begin the annuitization phases at an earlier date should the need arise.


Split Annuities

A split annuity combines two different annuities – one for generating a monthly income stream and the other to maintain the initial principal amount.

With this arrangement, an immediate annuity provides a specified amount of income each month while a deferred annuity accumulates over time.

This concept allows the consumer to receive regular income, while maintaining the original principal amount for use when the income from the immediate annuity has been completed paid out.


Settlement Options

The annuity contract will define the method by which the annuity owner can elect to receive benefit payments.

You may also hear this concept being referred to as settlement options, benefit options or annuitization options.

There are several payout options, the most common of which we will review in this lesson.


Life Annuity – With the Life Annuity option (also known simply as Life Only, No Refund), benefit payments begin upon annuitization and continue through the annuitant’s lifetime – regardless of how long or short of a time that may be.

Upon the annuitant’s death, no further payments will be made – even if more money was paid into the annuity than was paid out in benefits. Using our previous example, let’s assume that Kathy passed away just six months after turning 65.

In this case, she would have received just six annuity payments. If she elected a Life Only, No Refund payout option, no additional payouts would be made even though she had paid more in premiums than she received in benefits.

Settlement Options


Refund Life Annuity – Also known as Life Annuity, With Refund, this payout method offers a measure of protection against the loss of benefit payments caused by an early death.

With this option (as with the Life Only annuity), the annuity company will pay the benefits through the lifetime of the annuitant.

If upon the death of the annuitant, however, the total premiums paid into the annuity exceed the total of the benefits paid out, a lump sum payment for the difference will be made to the beneficiary.

Thus, it is guaranteed that at least the amount paid in will be paid out to either the annuitant or the beneficiary.

Settlement Options


Period Certain – The Period Certain, or Fixed Period, payout option establishes that annuity payments will be made for a certain period of time, with no promise to pay benefits for the lifetime of the annuitant.

Using our earlier example, if Kathy chose a 15-year period certain option, she would receive benefit payments for 15 years.

The benefits would end if she were to live longer than 15 years.

However, if she were to die earlier than that, the remainder of the payments that would have been made to her will continue to be paid to her beneficiary through the full 15 year term.

Settlement Options


Life with Period Certain – As the name implies, this payout method combines the Life Annuity and Period Certain payout options. This option is among the most popular selections because it provides a hedge against the losses that can occur if the annuitant dies shortly after annuitization.

With this payout method, the annuity company pays the benefits for whichever is longer – the annuitant’s lifetime or a certain time period (most frequently 5, 10, 15, or 20 years).

Using our earlier example, if Kathy selected a Life with 10-Year Period Certain and died six months after annuitization, the annuity company would continue to pay benefits to the beneficiary for the remainder of the 10-year term.

However, if she lived to age 90 – she would receive benefits for the 25 years she lived beyond the annuitization date.

Settlement Options


Joint and Survivor – With a joint and survivor annuity, benefits payouts are provided during the lifetimes of two “people”. While both annuitants are living, the full amount of benefits are paid as established by the annuity contract.

Upon the death of the first annuitant, benefits continue to the surviving annuitant but the amount may vary depending on the terms of the specific annuity. When the payout option is a “full joint and survivor” annuity, the payments continue in full until the death of the surviving annuitant.

Under a “joint and one-half survivor” annuity, one-half of the benefit amount will continue to be paid to the surviving annuitant upon the death of the first.

Cash Refunds – An annuity payout option that provides a cash payment to the beneficiary if the annuitant dies before receiving a specified amount of money from the annuity.

Settlement Options


Fixed Annuity Contract Provisions

Death Benefits

Since annuity payouts often stretch for long periods of time, it’s important to annuitants and owners that contract values are paid out to their survivors/beneficiaries upon their death.

With guarantees on the growth of fixed and indexed annuities, the death benefit is usually the accumulated value of the contract.

It’s important to understand how each annuity contract defines the death benefit and clearly explain this feature to clients.

And even more importantly, it should be understood that annuity death benefits do not pass to the beneficiary tax-free as with life insurance death benefits.


Death Benefit Settlement Options

Settlement options vary from company to company. Most common is a lump sum payment of either the accumulated value or the amount of premiums paid in up to the point of death.

However, some contracts allow for an extended payment of the death benefit, similar to how benefits are paid when the contract is annuitized.

There are also riders available to provide additional death benefits. These will be discussed a little later in this lesson.



Charges and Fees

In addition to interest rates and crediting methods, buyers must also be aware of fees and charges that can apply to annuities, especially administrative fees and surrender charges.

Administrative fees are levied to cover the set-up of the annuity, preparing statements, maintaining online access, changing beneficiaries and other miscellaneous insurer activities. At one time, it was common practice to charge a front-end sales fee or front-end load on fixed annuities.

However, this was so unpopular with buyers that the practice has largely been abolished. In general, administrative fees are lower on fixed annuities than on variable annuities because insurers can set the current interest rate lower than their expected return in order to cover miscellaneous administrative expenses.



Surrender charges are incurred when withdrawing funds, or “surrendering” an annuity. Most fixed annuities allow the owner to withdraw a specified partial amount each year – typically 10% of the account value – without being assessed a surrender charge.

Withdrawals above the allowable withdrawal amount, however, are usually subject to a surrender charge as outlined in the annuity contract.

Although the percentages will vary among insurance companies, the contracts typically define a declining schedule whereby the surrender charge will decrease over time.

For example, the surrender charge after Year 1 may be 10%; Year 2 – 9%; Year 3 – 8%; until declining to no surrender charge after Year 10.



Principal Guarantee

Most annuity contracts today defined a minimum guaranteed interest rate. This is an attractive feature because, in effect, it guarantees the contract will at least retain the value of the principal.

Loan Provisions

Most nonqualified annuity contracts do not provide provisions for taking loans against the annuity values. Due to the fact that amounts received as loans for contracts entered into after August 13, 1982 is taxable to the extent that the cash value of the contract immediately before the loan exceeds the investment in the contract. This makes loans less attractive.



Interest Rate Crediting

Interest is generally credited to fixed annuities in one of three ways.

· Portfolio Rate Method: With the portfolio rate method, the premiums from all buyers of a particular annuity are pooled in a common portfolio. All of these annuity owners will be credited with the same interest rate based upon the long-term performance of the portfolio – regardless of when the premium payments were made. Under the portfolio rate method, it’s not uncommon for the insurance company to credit the same rate for multiple years.



· New Money Rate Method: Also referred to as the bucket method, pocket method, or banded method, the new money interest rate is established based upon the timing of the premium payments – with the insurance company investing all premiums received during a specific time period in a pool referred to as a “bucket” or “pocket”. An interest rate will be declared for each bucket of premiums coming in – for example, all premiums paid in calendar year 2008 may be credited at a 3.5%, while premiums paid in 2009 may be credited at a 3.7%.

· Tiered Interest Rate Method: The rate credited under the tiered interest rate method is established based upon the cash value of the annuity and increases in steps or tiers. For example, a 3.5% rate may be credited for the first $50,000 of cash value; 3.75% for the next $50,000; 4.0% for the next $50,000; and 4.25% for the cash value above $150,000.



· Bonus rates: interest that is over and above the current or initial rate that is applied to premium deposits for a specified time period, generally the first year but at times the first few years. This is also referred to as premium bonus. Another type of bonus rate is known as annuitization bonus, which defines a specified interest rate that will be credited to the contract upon annuitization in addition to the regular interest. This is offered to encourage owners to hold the annuity through annuitization. You may also encounter persistency bonus rates, or an additional amount of interest credited upon specified anniversary dates, such as year one, year five, etc.

· Renewal rates: the interest rate that will be credited once the initial guarantee period has expired. This may be lower or higher than the initial rate, depending on market conditions.



Investment of Premiums

With a fixed annuity, the premiums paid by the owner are invested by the insurance company in the insurer’s general account.

With this approach, the annuity owner has no control over the investment.

The interest credited to the annuity account is a reflection of the performance of the insurance company’s general account – invested at the insurer’s discretion.

The value of the fixed annuity is measured in dollars.



Current & Guaranteed Interest Rates

Most fixed annuities today provide two interest rates – a current rate and a minimum guaranteed rate. Although the current rate can vary on a monthly basis as defined by the annuity contract, the interest credited is done so at a “fixed” rate for each defined time period.

For example, based on an annuity company’s general account performance, the current rate may be 4.63% in January; 4.88% in February; 4.75% in March, etc.

The guaranteed rate offers a measure of protection against poor performance by providing a minimum interest rate that will be credited to the annuity contract in the event the current rate dips below a specified level. Historically, the guaranteed rate has been in the 1.5% to 3.5% range. For example, let’s assume a 2.75% current rate is declared, but your annuity contract offers a guaranteed rate of 3.0%. In this case, the 3.0% guaranteed rate will be credited to the funds in the annuity contract for the specified period.



Who Can Sell Fixed Annuities?

Currently, fixed annuities as discussed in this lesson are considered insurance products. As such, individuals who are licensed with their state insurance board for the sale of insurance products can sell fixed annuities.

These individuals include insurance agents, bank employees, financial planners, investment advisors, and others in the financial services profession. There are presently no requirements for these individuals to hold a securities license or professional designation.



Variable Annuity Contract Provisions

Investment of Premiums

With a variable annuity, the premium payments are invested at the direction of the annuity owner – among a selection of investment choices known as subaccounts – as opposed to being invested in the insurer’s general account. With a variable annuity, the potential exists to earn higher interest rates than offered with a fixed annuity.

However, based on performance of the investment selections or allocation, it’s also possible that the variable annuity will be credited at a lower rate than may have been earned with a similar fixed annuity.

As such, it’s considered that the annuity owner bears the investment risk with a variable annuity. It’s also increasingly common for insurance companies to offer a guaranteed rate to offer some degree downside protection.


Subaccounts

The annuity owner can generally choose among several variable subaccounts for investment of the premiums.

The owner is not limited to just one account – varying percentages can be allocated among several subaccounts according to the owners risk tolerance.

Typically, variable annuities include accounts that meet a wide range of investment criteria. Often, there will be several “guaranteed” funds from which to choose.

Similar to the operation of a fixed annuity, funds within these accounts will be credited with a guaranteed rate of interest.

The value of the variable annuity is measured in units, as opposed to in dollars like fixed annuities.



Moving Funds Between Accounts

In addition to selecting the subaccounts in which to invest the annuity funds, the owner also has the flexibility to transfer funds between the various subaccounts offered.

This may be done in response to changing market conditions or shifts in risk tolerance as the annuity owner moves between different life cycles as the annuity owner’s life cycle or financial circumstances change.

To protect the annuity owner from the impact of frequent short-term transfers, most annuities place restrictions on the frequency and dollar amounts of transfers or reallocations.

Insurance companies often provide tools to assist the annuity owner in properly meeting their defined goals through automatic rebalancing and dollar cost averaging.



Automatic rebalancing is intended to keep a variable annuity owner on track with regard to a desired portfolio mix of investments. That mix, might, for example, involve 75% equities and 25% bonds.

During a particular period, if equities outperform bonds to the extent that the total contract value is 85% equities and 15% bonds, the contract would automatically rebalance the portfolio to the desired 75%-25% mix. A contract might provide for re-balancing to occur on a quarterly, semi-annual or annual basis.

Some advisors object to rebalancing, contending that it does not allow a policyowner to “ride the wave” and take advantage of a strong, perhaps extended upward trend in a particular class of investments. If this is a concern, the option can be cancelled, and resumed at any time.



Dollar Cost Averaging (DCA) is a strategy designed to impose discipline in a savings program while acquiring shares at a lower cost than could be achieved if one attempted to “time” the market (buy when prices are determined to be at their lowest, a technique that has never proven to be consistently effective).

Under DCA, a VA policyowner pays a fixed premium at regular intervals (monthly, quarterly, semi-annually or annually) regardless of the cost of VA accumulation unit values.

During rising markets, less units will be purchased; during falling markets, more units will be purchased. This technique can result in a lower average cost of units than if the policyowner employed a less disciplined approach.



Death Benefit

Most nonqualified annuity contracts, including variable annuities, provide that if the annuitant dies before the contract has started paying out benefits, a death benefit will be paid to the beneficiary named in the annuity contract. This is not a true “death benefit” as is paid from a life insurance policy at the death of the insured, but it does offer the annuity holder a guarantee that not all funds paid into the annuity will be lost if death occurs before annuity benefit payments begin.

The exact manner in which the amount of the death benefit is calculated varies from one contract to the next, particularly among variable annuity contracts. One garden-variety method makes the death benefit equal to either the amount of premiums paid or the annuity’s account value. Generally, any surrenders made against the contract are subtracted from this amount when arriving at the death benefit figure.



Another method determines the death benefit to be the largest of either the contract value, the premiums paid into the annuity credited with a certain (usually modest) interest rate, or the value of the annuity contract on the most recent policy anniversary plus any premiums paid since then.

A variable annuity holder may derive some peace of mind knowing that the beneficiary will receive a death benefit payment that is not calculated solely on the current annuity value of the contract upon the day of death.

Death benefit guarantee is a guaranteed payment (or a payment determined by a guaranteed formula) regardless of investment performance in the event of the annuitant's death. This is useful when the annuitant requires that a certain amount be available upon her death, regardless of investment performance.



When contracts provide cash surrender benefits, benefits available prior to maturity shall not be less than the present value as of the date of surrender of that portion of the maturity value of the paid-up annuity benefit which would be provided under the contract at maturity arising from considerations paid prior to the time of cash surrender reduced by the amount appropriate to reflect any prior withdrawals from or partial surrenders of the contract, such present value being calculated on the basis of an interest rate not more than 1 percent higher than the interest rate specified in the contract for accumulating the net considerations to determine such maturity value, decreased by the amount of any indebtedness to the company on the contract, including interest due and accrued, and increased by any existing additional amounts credited by the company to the contract.



In no event shall any cash surrender benefit be less than the minimum nonforfeiture amount at that time. The death benefit under such contracts shall be at least equal to the cash surrender benefit.



Living benefit guarantee is a benefit that a contract holder can exercise while still living that guarantees certain payouts regardless of investment performance. There are three main types of living benefits guarantees: guaranteed minimum income benefit (guarantees a minimum income to the annuitant), guaranteed minimum accumulation benefit (guarantees a future account value), and guaranteed minimum withdrawal benefit (guarantees a return of principal or of a protected withdrawal value over time).



Charges and Fees

There are several fees associated with variable annuities. Annual administrative fees are assessed to variable annuities, although they are handled differently than with fixed annuities.

Instead of a single fee, the charges are deducted from the various subaccounts based on the percentages allocated to each fund.

For example, if 25% of the funds are placed in each of four subaccounts, one-fourth of the administrative fee will be charged to each account.

In addition, each of the variable annuity’s investment accounts may be levied additional fees to recoup the expenses associated with investments such as fund management fees or investment advisory fees.



Mortality and expense charges, or M&E charges, cover the insurance expense for the variable annuity’s death benefit. As with the administrative fees, this charge is usually a small percentage (less than 2%) that is deducted proportionately from the various subaccounts on an annual basis.

Transfer fees are assessed on variable annuities, but not applicable to fixed annuities. These fees are charged when the annuity owner moves or transfers funds among the different subaccounts offered. Generally, transfer fees are flat dollar amounts that are deducted from the account at the same time the transfer is made.

Surrender charges apply when withdrawing funds, or “surrendering” a variable annuity and are handled as previously explained in the section on fixed annuities.



Who Can Sell Variable Annuities?

Since variable annuities are classified as securities products, they are regulated by the Securities and Exchange Commission (SEC) along with the Financial Industry Regulatory Authority (FINRA, formerly known as NASD or National Association of Securities Dealers). To sell variable annuities, individuals are required to earn a Series 6 license by passing FINRA’s Investment Company/Variable Contracts Products Limited Representative exam.



Equity Indexed Annuity Contract Provisions

Equity-indexed annuities (also referred to as EIAs) are a relatively new arrival in the annuities marketplace, making their U.S. debut in the mid-1990’s.

They evolved from the consumer’s desire to merge the perceived safety and guarantees of a fixed annuity with participation in the “market” and some control over the investment aspect as offered by variable annuities.

Although some people consider them to be a hybrid annuity product, they are currently classified as fixed annuities – however, this is subject to a great deal of scrutiny and attention from federal regulators.


There are many interest crediting formulas and index periods or terms used to determine how interest is credited to the EIA. The index term is the time period during which the market index’s performance is measured, when the annuity owner has funds linked to the index. This term can be an annual period or could last up to ten years or more.

· Total Interest Methods: Total interest methods calculate the rate based on the interest rate change over the entire index term, which as previously mentioned can range from one to several years. Total interest methods include Long-Term Point-to-Point, Long-Term Point-to-Point with Average End, High Water Mark, and High/Low Anniversary Day Look-Back.

· Annual Interest Rate Method: As the name suggests, annual interest rate methods calculate the interest rate on an annual basis, as opposed to over a longer period of time. The most common annual interest rate method is Annual Reset Point-to-Point.

· Combination Methods: Combination methods combine features of both total interest and annual indexing methods, which provides for interest crediting more often than under total interest methods, but less frequently than annual methods.



What is an Indexing Method or Crediting Strategy?

An indexing method determines the change in the relevant index over the policy term of the equity-indexed annuity for the purpose of calculating the interest that will be credited to the EIA.



· Annual Reset: also known as the “ratchet” or “cliquet” method, the annual reset indexing method “resets” the interest rate each year like traditional fixed annuities. This method uses the index closing level at the start of the contract year, and the ending closing level at the contract’s anniversary date each year of the policy term. The annual interest rates are then added together to determine the interest rate for the term. An interesting feature of this method is that losses are disregarded. If the index movement is negative for the year, it’s treated as a zero percent gain and receives no interest credit for that year.

Different EIAs credit interest differently, even when using the annual reset method. Some add the interest received from one anniversary period on top of the gains received in previous periods to create a compounding effect. Others use a “simple interest” approach, adding the interest rates together to arrive at the total interest rate figure for the entire policy term, and other use a monthly average.



· High Water Mark: this method, also known as the high water anniversary day look-back method, uses sets an index figure as a starting point when the annuity is purchased. The insurance company “looks back” at the index value at various points in the contract (usually the anniversary date) and compares these “water marks” to the starting point. It then selects a single “high water mark” during the contract term and credits the EIA with a rate based on the difference between the starting index figure and its high water mark figure. If the starting point is never exceeded during the contract term, the EIA’s minimum guaranteed interest rate comes into play.

A variation of this method is the high/low anniversary day look-back, in which the start point is the lowest index value at any point during the contract term and the end point is the highest index value during the indexing period.



· Long-Term Point-to-Point Indexing Method: in long-term point-to-point (also known as the European method), the growth of the index is measured over a longer time period – frequently six or seven years. This method compares the change in the index at two distinct points in time – usually the beginning and ending dates of the contract term. The percentage change between these two points is multiplied by the participation rate to arrive at interest rate that is credited to the annuity.

· Combination – Biannual Reset Indexing Method: as the name implies, combination methods combine features of both total interest and annual interest indexing methodologies. This usually results in crediting interest more frequently than the long-term point-to-point method but less frequently than with the annual reset method. In the bi-annual reset method, instead of calculating the percentage change on an annual basis, the change is calculated every two years. That change is added or compounded to previous percentage changes to arrive at an overall rate.



· Asian Method: the starting and ending points are determined by averaging several points during the indexing period. EIAs using this method often average the 12 monthly index values during the final year to arrive at the ending point, serving to minimize the impact of declining value at the end of the contract term.



Yield Spreads

Also referred to as “Asset Fees”, yield spreads reduce the risk to the insurer by deducting an asset management fee prior to crediting interest to the EIA.

In the annual yield spread, the crediting rate is simply the annual index return less a spread or asset-based fee.

A term yield spread uses the same approach over a multiple year period.



Cap Rate

The cap rate serves to limit the amount of growth in the applicable market index that will be credited to the EIA.

While not a feature of all annuity contracts, some EIA contracts will set an upper limit or “cap” on the amount of growth that will be passed on to the EIA owner.

The cap rate is generally expressed as a percentage. Consider in the previous example provided under “Participation Rate” that the annuity contract established a 5% cap rate.

Even though the participation rate and index growth combined to provide a 6% interest rate, the owner would only be entitled to 5% because of the “cap”.



Participation Rate

The participation rate in an equity-indexed annuity is used to determine the percentage of the market index’s growth that will be credited to the EIA.

Typically, participation rates range from 60% to 110% and are applied to the index growth to arrive at the interest crediting rate.

Consider an EIA for which the market index experienced 8% growth and has a participation rate of 75%.

Since this annuity “participates” in 75% of the index growth (8% in our example), the interest credited would be 6% – or 8% x 75%.



Some EIAs offer a choice of policy terms with a different participation rate for each term. For example, if the annuity owner selects a six-year policy term, the participation rate may be 75%, but if the owner selected a 10-year term, the EIA may have an 85% participation rate.

Participation rates can be guaranteed or non-guaranteed as stated in the annuity contract. While most EIA contracts typically guarantee the initial participation rate for the full length of the first contract term, many reserve the right to set a new participation rate for subsequent terms should the owner enter into another term.

Annuity contracts with non-guaranteed participation rates often have a “renewal floor” which is a minimum level rate the company uses during renewal periods following the initial rate guarantee period.



Minimum Guaranteed Interest Rate

Almost all EIA contracts provide a minimum guaranteed interest rate – typically 3% credited to a minimum of 90% of the initial premium.

This minimum guaranteed rate is generally paid when the applicable market index does not increase over the measurement period.

The existence of this minimum guarantee prevents the annuity owner from losing principal under less desirable market conditions and adds credence to the belief that EIAs are fixed annuities.



Fees and Expenses

Not all EIAs impose separate fees, opting instead to set the participation rate and other policy provisions at such a level as to generate a sufficient return for the insurance company to cover administrative expenses and other costs.

However, some EIAs will assess an administration fee charged against the account value. This charge generally ranges from 0.5-1%.



Who Can Sell Equity-Indexed Annuities

Since equity-indexed annuities are currently classified as fixed annuities, those licensed to sell annuities can also sell equity-indexed annuities.

In Lesson 6, we will discuss recent action by FINRA and the SEC to reclassify equity-indexed annuities as securities products, which would require additional licenses to sell EIAs.

However, presently there is no requirement for a securities license.



Riders

There are several riders available with annuities. The most common is the life insurance rider, which ensures that a death benefit will be available in the event of the annuitant’s death.

Generally, the death benefit at least returns the balance of the premium payments if benefits have not been fully collected.


Riders

Living Benefit Riders

· Guaranteed Minimum Accumulation Benefit (GMAB): guarantees a minimum accumulation of principal to safeguard against poor investment performance.

· Guaranteed Minimum Income Benefit (GMIB): defines a minimum income amount that will be paid upon annuitization regardless of investment performance and actual account values.

· Guaranteed Minimum Withdrawal Benefits (GMWB): provides a guarantee that, at a minimum, the total amount of the paid-in premiums can be systematically withdrawn over a specified time period.


Long-Term Care rider: provide benefit payments to cover the annuity owner’s long-term care requirements.

· Crisis waiver: Waivers of surrender charges in certain crisis situations, such as confinement to a nursing home, disability, or diagnosis of serious disease. Surrender charges are assessed upon the surrender of an annuity contract or upon withdrawal of more than the policy's free withdrawal amount.

Riders


Lesson 6Qualified Plans and Annuities


Qualified vs. Non-Qualified Annuities

At first glance, you may think a “non-qualified” annuity would be less desirable than a “qualified” annuity.

However, these terms do not reflect the quality of the annuity product or insurance company. Instead, they refer to the taxation of retirement plans.

A qualified annuity is one that meets guidelines established by the Internal Revenue Code for use as part of a qualified retirement plan.

In contrast, a non-qualified annuity is one that is not used as part of a qualified retirement plan. Where a qualified retirement is offered by an employer to its employees, a non-qualified annuity can be purchased by individuals or business entities outside of employer-provided retirement plans.

Lesson 6: Qualified Plans and Annuities

Generally, a qualified retirement plan is an employee benefit arrangement, which an employer offers the employee.

There are several different types of qualified plans, such as profit-sharing plans, 401(k) plans and employer stock ownership plans. A detailed explanation of these is beyond the scope of this course.

However, it is important to understand that while these plans are designed to provide an employee with some type of retirement benefit, most employees have little control over the type of plan offered by their employer or how the plan’s funds are invested.

The nonqualified annuity offers a method of retirement planning over which the employee retains a much greater degree of control.



From a financial planning perspective, it is important to note that for high-income taxpayers who, because of their income levels, cannot take advantage of IRAs, the use of a nonqualified annuity to accumulate funds for retirement purposes can be attractive.

While it is true that premiums paid into a nonqualified annuity are not income tax deductible and benefit payments from such an annuity will be partially taxable, there is no limit on the amount of funds that may be placed in a nonqualified annuity.

And, of course, the interest earned on the funds inside the annuity is tax deferred.



Defined Benefit

Prior to the Employee Retirement Income Security Act of 1974 (ERISA), the plan most frequently used among small and medium-sized corporations was the defined benefit pension plan. The plan gained its popularity primarily because the employer, to a considerable extent, could control the benefits and the cost distribution of the plan.

ERISA imposed several restrictions on defined benefit pension plans that are not imposed upon other types of plans. These restrictions have adversely affected the popularity previously enjoyed by these plans.

A defined benefit pension plan must have definitely determinable benefits. The employer's contributions may be dependent on a defined or assumed benefit for retirees or on a contribution formula. They may not be dependent on the employer's profits.


The benefits under the defined benefit pension plan are set by a predetermined formula.

Because retirement pension benefits are typically paid for the life of the retiree, the annual contributions necessary to fund the defined benefits are determined by an actuary.

Among the factors taken into account are the life expectancies of participants, interest rates, salary levels upon which benefit levels will be based, and projections of employee turnover.

The Code specifically requires that each of the actuarial assumptions and methods be reasonable and, "in combination, offer the actuary's best estimate of anticipated experience under the plan".

Defined Benefit


By adopting a given benefit formula, the employer may provide benefits in proportion to length of service, amount of income, or by any method not considered discriminatory.

It is through the proper selection of a benefit formula that an employer can reward those individuals who have contributed the most to the success of the business.

The type of benefit formula is of paramount importance to the pension planner in order to satisfy the needs and desires of the business owners or other human resources decision makers.

Defined Benefit


Defined Contribution

By contrast, a defined contribution plan approaches retirement security planning from the other end: the employer's obligation is not to pay a defined benefit amount upon the employee's retirement, but rather, to contribute a defined amount into the plan for credit to a separate account for each employee.

Thus, the ultimate benefit to be realized upon retirement will be dependent upon two elements: the cumulative amount contributed into the plan account (including forfeitures from other plan participants), and the investment performance of the account before, and during, the retirement payout period.

The traditional profit-sharing plan, under which the annual contribution to the retirement account is based on a portion of the employer's net income for the year, is a classic form of defined contribution retirement plan.


In today's economy, most employment based qualified plans are defined contribution plans.

Defined contribution plans are typically structured with the employer contributing to the plan an amount equal to a specified percentage of the employee's wage or salary, such plans frequently allowing for voluntary contributions by the employee as well. It is also common for the employee to be given the ability to select among several investment vehicles for the placement of the funds in the plan account.

Defined Contribution


IRA

IRAs, also known as Individual Retirement Accounts or Individual Retirement Annuities, were created by ERISA in 1975.

The initial concept was simple: permit individuals to deposit money into special accounts and then allow that money to grow tax-free until its withdrawal at retirement

Since their introduction, however, IRAs have been subject to a myriad of legislative changes — some expansive, others restrictive.

An individual retirement plan is a custodial account established by an individual to receive contributions of investment increments and, at retirement or death, to disburse the accumulated assets to the individual or the individual’s beneficiary.


Individual retirement accounts allow individuals to establish and control their own savings plans (generally for retirement, but useable for certain other financial needs) and enjoy some of the same major tax advantages accorded to participants in qualified retirement plans of employers.

Contributions to a traditional IRA may be tax deductible; however, when money is withdrawn from the account, it is taxed as ordinary income.

IRA


Roth IRA

The Roth IRA is named after its creator, Senator William Roth of Delaware, who, as Chairman of the tax-writing Senate Finance Committee, advocated the concept of a sheltered account which would receive after-tax (i.e., non-deductible) contributions, in which the income would compound tax-free and would also be tax-free when distributed to the account holder after retirement age.

While contributions made to a Roth IRA are not deductible as with a Traditional IRA, funds distributed from a Roth IRA may be received completely free of any income tax, provided certain conditions are satisfied.


TSA

A "tax-sheltered annuity," known variously as a TDA (tax-deferred annuity), TSA or 403(b) annuity, is a contract or custodial account used to fund a special type of retirement arrangement available to employees of certain tax-exempt employers, known as §501(c)(3) organizations.

A tax-deferred annuity plan is a retirement plan that, if operated properly by a qualified employer, is tax-exempt.

Basically, 403(b) plans are similar to 401(k) plans. Just as with a 401(k) plan, a 403(b) plan lets employees defer some of their salary. In this case, their deferred money goes to a 403(b) plan sponsored by the employer.

This deferred money generally does not get taxed by the federal government or by most state governments until distributed.


There are three benefits to contributing to a 403(b) plan. The first benefit is that the plan participant does not pay tax on allowable contributions in the year they are made.

Allowable contributions to a 403(b) plan are either excluded or deducted from income.

The second benefit is that earnings and gains on amounts in a 403(b) account are not taxed until withdrawn.

The third benefit is possible eligibility for the credit for elective deferrals.

TSA


401(k)

401(k) plans allow eligible employees to defer compensation or bonuses and contribute the funds to an employer-sponsored profit sharing plan.

Known as cash or deferred arrangements (CODAs), they are funded entirely or in part through salary reductions elected by the employees.

Since participation is voluntary, employers will often encourage participation by matching employee contributions.

These matching contributions are typically limited to a maximum percentage and/or maximum dollar amount.


Among the benefits of participation in a 401(k) plan:

· Provides a tax-deferred retirement savings medium

· Allows employees a degree of choice in the amount they wish to save under the plan

· Provides flexibility in selecting investment options for the contributions

· In-service withdrawals may be available for “hardships

401(k)


SEP

A SEP, or Simplified Employee Pension, is designed to help smaller employer’s establish a retirement plan for their employees without the administrative costs and governmental paperwork that burden most qualified plans.

It is an employer-sponsored plan under which plan contributions are made to the participating employee’s IRA.

Tax-deferred contribution levels are generally significantly higher than the maximum contribution limit for traditional IRAs.

One major advantage is that a SEP is totally portable since funding consists entirely of IRAs for each employee and employees are always 100% vested in their benefits.


Annuities and Retirement Planning

Although the annuity can be used for many purposes, probably its best and most frequent use is retirement planning.

Retirement has been the focus of much attention in recent years. Since people are living longer than at any prior time in history, there are more retirement years to be planned for and paid for.

Americans of the baby boomer generation, those born between 1945 and 1964, are quickly nearing retirement age and have begun planning for their retirement years in earnest.

Further, the downsizing of major American corporations is symptomatic of an economy in which employees cannot rely on their employers to finance their retirement.


As a result of these and other factors, there has been a steadily increasing interest in the financial aspects of retirement.

Most Americans expect to receive Social Security benefits at retirement, and many are participants in qualified retirement plans provided by their employers.

Experts warn, though, that if baby boomers are to afford the retirement lifestyle they seem to want, these two sources of retirement income will not suffice.

Personal savings must make up the difference.



One of the best vehicles for accumulating funds to supplement retirement income from Social Security and qualified retirement plans is a nonqualified annuity. The use of the labels “qualified” and “nonqualified” refer to whether the annuity is used as part of a retirement plan that is “qualified” under certain sections of the Internal Revenue Code.

A qualified annuity is one that is used as part of, or in connection with, a qualified retirement plan. A nonqualified annuity is one that is not used as part of any qualified retirement plan. If the annuity is labeled nonqualified, this simply means that it may be purchased by any individual or entity and is not associated with an employer-provided plan.

With the large number of baby boomers hitting retirement age, a great deal of attention has turned to looking at ways to help retirees receive their retirement benefits.



One term used for this type of planning is “income distribution planning.” This activity of planning to receive funds is, in some ways, the opposite of planning to accumulate retirement funds, which has received far greater attention.

With the ability to provide a life-long income stream that an individual cannot outlive, annuities can be an ideal vehicle for income distribution planning. Most annuities offer payout options as part of the contract.

Thus, an annuity holder can typically elect to receive the funds in an annuity over his lifetime, over the lifetimes of the annuity holder and his spouse, over a certain number of years, in a certain monthly amount, or according to one of several other alternatives typically available. Other names for these payout options are settlement options and payment contracts.



Lesson 7Taxation of Annuities


Taxation of Qualified vs. Non-Qualified Annuities

The taxation of withdrawals and application of early withdrawal penalties applies only to accumulated interest for non-qualified annuities.

However, the entire benefit amount received under qualified retirement plans, Section 403(b) annuities, and Individual Retirement Arrangements is subject to income tax and early withdrawal penalties.

This is because the funds that are contributed to annuities within qualified plans are made with pre-tax dollars; in other words, no income tax is paid on the funds at the time they are placed into the annuity as long as it is within a qualified plan.

Non-qualified annuities are funded with funds on which income tax has already been paid, so only the interest earned is typically subject to taxation as ordinary income.

Lesson 7: Taxation of Annuities

If a non-qualified annuity is transferred by gift or sale, the transaction terminates the tax deferral on the income build-up within the plan.

The new owner must report as income the different between the cash surrender value of the contract and the amount placed in the annuity by the original owner. The annuity donor may also be subjected to gift taxes.

In general, annuities held within qualified plans cannot be sold or transferred by gift unless first distributed from the plan to the original owner or the owner’s estate, where the entire amount of the plan must be reported as ordinary income.



Beneficiaries of non-qualified annuities that have not entered the annuity phase must take distribution of the entire plan within five years of the death of the owner, unless the beneficiary is also the annuitant and payments begin within one year of the owner’s death.

The first death of an owner of a jointly owned annuity contract is used to determine the five-year distribution period.

If the beneficiary is the surviving spouse of the owner, the distribution rules do not apply and the beneficiary is considered to be the new owner.

The five-year distribution rule and the transfer an annuity’s ownership to a surviving spouse are not available in the case of qualified annuities, limiting their flexibility as a planning vehicle.



In regards to ordinary income tax adjustment, the calculation of the portion of an annuity pay-out that is taxable as ordinary income upon the death of an annuitant (in an annuitant-driven contract) or of an annuity owner (in an owner-driven contract).



Taxation Related to Premiums

While this lesson is focused on income taxation as it relates to equity-indexed and fixed annuities, it’s worth mentioning deductibility of premiums.

Generally, premiums or contributions paid into an annuity are not deductible from the annuity holder’s income.

Thus, if a married couple in their 50s decides to place a certain sum of money into a deferred annuity contract each month as part of their overall retirement plan, the monthly amount will not generate any current income tax savings although the interest earned on the funds once they are inside the annuity will be income-tax deferred.

This general rule of non-deductibility applies whether the premium is a single payment or paid in installments over many years.


Cash Value Accrual and Section 10168.2 of CIC

Annuities are governed by Internal Revenue Code (I.R.C.) §72.

Annuities offer the advantage that growth during the accumulation phase is tax deferred, meaning that there is no tax liability until annuity payouts are made, funds are withdrawn, or upon the death of the annuitant.

In general, Code §72 provides that amounts received from annuity contracts are includable in gross income except when they represent a reduction or return of premiums or other consideration paid.

In defining this, Code §72 differentiates between "amounts received as an annuity” (payouts received during annuitization phase) and "amounts not received as an annuity".


Amounts not received as annuities include policy dividends, returns of premiums, payments in full discharge of the issuer’s obligation under the contract which are in the nature of a refund of the consideration, lump sum payments upon surrender redemption or maturity of the contract, and partial withdrawals from annuity contracts.

In California, agents shall refer to Section 10168.2 (for contracts issued before January 1, 2004) and 10168.25 (for contracts issued between January 1, 2004 and January 1, 2006) for specific rules pertaining to minimum nonforfeiture amounts

Cash Value Accrual and Section 10168.2 of CIC


Partial Surrenders or Withdrawals

Partial surrenders or cash withdrawals from an annuity prior to the maturity date stated in the contract will be treated as taxable income to the extent that the cash value of the contract exceeds the policyholder’s investment or premiums paid.

In the past, under the "Cost Recovery First" rule, the first amounts withdrawn under an annuity contract were treated as a return of capital to the extent of the owner’s investment.

This process is effectively reversed so that "credited interest" is now taxed as withdrawn.

The rule applies to existing contracts but not to investments made or premiums paid prior to August 14, 1982.


In addition, early withdrawals (prior to the owner’s attaining age 59 1/2) may incur a penalty tax of 10 percent of the amount includible in gross income. Loans are treated as distributions for purposes of these rules. For contracts issued after January 18, 1985, the 10 percent penalty applies to early withdrawals on all amounts includable in gross income.

The 10 percent penalty will not apply to a distribution made:

· on or after the policyholder reaches age 59 1/2;

· on account of the death of the policyholder;

· due to the disability of the policyholder;

· in substantially equal periodic payments made over the policyholder’s life;

· of an amount invested before August 14, 1982; or

· in the case of a distribution from a qualified pension plan.



It should be noted that the application of the 10 percent penalty and these exceptions generally parallel the early withdrawal penalty applicable to IRAs and other qualified plan accounts under I.R.C. §72(t).



Loans and Assignments

There are insurers that will allow an investor to borrow a portion of their tax-sheltered annuity, but many insurers will not allow loans. The chief reason may be due to how the Internal Revenue Service might view it. The IRS has convinced Congress to enact legislation restricting the amount and period of any loan. Those restrictions include:

1. A loan on an account that is less than or equal to $10,000 will be taxable if it exceeds 100 percent of the employees account or $10,000, whichever is less.

2. A $10,000 or greater loan is taxed if the investors account is more than $10,000 but less than $20,000.

3. If the value of the account is more than $20,000 a loan is also taxable if the amount borrowed is 50 percent of the value of the account or $50,000, whichever is less. Any net loan repayments that were made by the employee during the preceding 12-month period would reduce that $50,000 loan.


4. Loans must be repaid within five years.

5. Loans, or portions thereof, that are not repaid on time are subject to taxation. They could also be subject to a 10 percent penalty tax.

6. If a loan is in default, the insurance company is required to notify the IRS and the investor.

7. If the loan ever exceeds the value of the employees account, any excess is taxed.

Insurers may also have repayment requirements. Insurers are also likely to limit how much of the fund may be borrowed, often based on how much must remain in the account.

Some insurers will automatically take repayments from the account values if the repayments are not made on time. While this type of forced repayment may be considered a withdrawal, and have related penalties, they are likely to be minor when compared to a loan default.




Most insurance companies do not provide provisions for taking loans against the annuity values.

Due to the fact that amounts received as loans for contracts entered into after August 13, 1982 are taxable to the extent that the cash value of the contract immediately before the loan exceeds the investment in the contract, loans have become less attractive.

In addition, there are requirements that loans must be repaid within five years, and IRS notification rules in the event of default.

Some insurers automatically take repayment amounts out of new premium payments or cash values, which can impact long-term value of the annuity.



It is a basic tax principle that “fruit” is attributed to the “tree” on which it grows. Without the transfer of the underlying contract, a gift or gratuitous assignment of income will not shift the taxability of the income away from the owner of the contract. This applies to income accumulated on the contract before the assignment as well as any accruing after. Withdrawals and annuity payments are taxable to the owner, even if paid to a third party.


Taxation of Amounts not Received as Annuities

I.R.C §72(e) governs the taxation of "amounts not received as annuities".

Amounts not received as annuities include policy dividends, returns of premiums, payments in full discharge of the issuer’s obligation under the contract which are in the nature of a refund of the consideration, lump sum payments upon surrender redemption or maturity of the contract, and partial withdrawals from annuity contracts.

Annuitants receiving such payments after the annuity starting date must include them in gross income.

In the case of payments received before the annuity starting date some amounts not received as annuities are taxed under the income-first rule and some under the cost-recovery-first rule.


Gain or Loss on Surrender, Replacement, or Exchange

· Gain on surrender: Any gain realized upon surrender of an annuity contract is taxed as ordinary income. The cash surrender value of the contract is included in gross income only to the extent that it, together with amounts previously received and excluded from gross income, exceeds the sum of premiums paid. Discounted premiums are taken at the actual amount paid in plus any (interest) increment required to be reported as income.

· Loss on surrender: The loss incurred upon the surrender of an annuity contract by the purchaser-annuitant is deductible as ordinary loss, where he entered into the transaction for profit [George M. Cohan, 11 B.T.A. 743, aff’d 39 F.2d 540; I.T. 3567, 1942-2 C.B. 105, as modified by Rev. Rul. 61-201, 1961-2 C.B. 46]. In the Cohan case, only one premium was paid on a deferred annuity contract. The loss resulting from the lapse of the contract was held deductible in full.



The basis of a surrendered annuity contract is its cost, less the amounts previously received under the contract which were properly excluded from gross income.

Section 1035 non-taxable exchanges: No gain or loss is recognized if the taxpayer exchanges or replaces one annuity for another covering the same annuitant. If an annuity is surrendered and the proceeds are applied to an annuity with another company, no gain is realized. The new contract takes the old contract’s basis. The exchange of an annuity contract for a life insurance policy, however, is a taxable transaction.



Gift of an Annuity Contract

The tax consequences to the donor who transfers an annuity contract by gift will depend upon whether the contract was issued before or after April 22, 1987.

Code §72(e)(4)(C) deals with transfers by individuals for less than full and adequate consideration after April 22, 1987, and provides that the donor realizes income at the time of the gift to the extent that the cash surrender value of the contract exceeds the investment in the contract.

In effect, the transfer of a post April 22, 1987 annuity contract by gift triggers the taxation of prior tax-free build up of income in connection with the contract.

This rule does not apply to transfers between spouses or between former spouses incident to divorce.



The income-triggering rule does not apply to gifts of annuity contracts issued prior to April 23, 1987.

In such cases no income is recognized by the transferor at the time of the transfer, even if the cash value of the contract at that time exceeds the transferor’s investment.

The transferee would take over the contract with an investment in the contract equal to the transferor’s investment at the time of the transfer (applying the carryover basis principal).



The recipient of a gift of an annuity contract will report income from the annuity payments in the normal method, using the exclusion ratio.

The annuity starting date and the expected return under the contract are determined as though no transfer had taken place.

In determining the investment in the contract all premiums and other consideration paid or deemed to have been paid (net of any amounts received tax-free) by both the transferor and the transferee are taken into account.



Gain or Loss on the Sale of an Annuity

If the owner of an annuity contract sells it, he realizes gain to the extent the sale price exceeds the policy’s cost.

This cost equals the sum of premiums paid before the sale, less the excluded portion of any annuity or other payments received before then.

Courts have held the seller’s gain to be ordinary income. Conceding an annuity contract to be a capital asset, the courts held that the seller’s gain resulted from the interest earning represented by the increased cash value, and was taxable as ordinary income produced by a capital asset.



If the cost of the policy exceeded the sale price, the question of whether the seller would realize ordinary or capital loss remains unanswered; it is generally believed that the loss would be ordinary.

A long-lived annuitant’s tax-free recovery, which is subtracted from basis, may exceed his investment in the contract. However, while the contract’s basis may fall to zero, it can never become negative.



Annuity Death Benefit

If the annuitant dies before annuity payments begin, his beneficiary is entitled to a "death benefit" (in effect, a refund of policy values).

If it – plus all dividends received – exceeds the sum of premiums, the excess is includable in the beneficiary’s gross income. The death benefit does not qualify for the income tax exclusion under §101(a)(1), since the annuity contract is not a life insurance policy.

If the beneficiary, within 60 days after the annuitant’s death, elects an installment or life-income option, no constructive receipt of the whole benefit takes place.

Instead, the periodic payments are taxed under the general annuity rule. The beneficiary, in computing the excludable amount, uses the annuitant’s total investment and his or her own life expectancy.


The beneficiary’s reportable income from the annuity qualifies as income in respect of a decedent, to the extent it represents the excess of the death value over net premiums paid. Thus, he or she may be entitled to an income tax deduction for estate tax paid.

Annuity Death Benefit


Tax Deferred Compounding

From the moment that gains are added to the investment, those gains also grow without being taxed until they are paid out (taxes are deferred).

This maximizes the benefit of compounding because both investment and gains grow without being taxed until a future date.


Amounts Received as an Annuity

When examining taxation during the annuitization phase, the objective is to determine which portion of each periodic annuity payment constitutes a return of capital and which part is interest income.

Only the latter is taxed. The portion of each periodic payment that is considered a return of capital is excluded from gross income.

To qualify for this favorable annuity tax treatment, two key rules must be met:

· The non-natural person rule (IRC §72(u)

· Post-death distribution rules (IRC §72(s)


The non-natural person rule

To qualify for favorable annuity tax treatment, it is required that the holder of the annuity be a natural person.

If a corporation, for example, owned an annuity contract, each year’s increment (i.e., inside build-up) in equity in the contract would be taxable to the corporate holder as it accumulated; the tax deferral feature would, thus, not apply.



Post-death distribution rules

For annuity contracts issued after January 18, 1985, annuity tax treatment under Code §72 will be denied unless the contract provides that:

1. If the annuity holder dies on or after the annuity starting date but before the entire interest in the contract has been distributed, the remaining portion of interest will be distributed at least as rapidly as under the method of distribution being used as of the date of his death, and

2. If the annuity holder dies before the annuity starting date, the entire interest in the contract will be distributed within five years after the death. This 5-year requirement is deemed to be satisfied in cases in which the annuity payments are to continue for the life of a designated beneficiary (or over a period not longer than his life expectancy), provided that distributions to the beneficiary begin not later than one year after the original annuity holder’s death.



General Rules for Amounts Received as Annuities

Annuity Exclusion Ratio

A fixed fraction of the annuity’s guaranteed periodic payments is considered return of capital. This fraction is called the exclusion ratio. The exclusion ratio equals the investment in the contract divided by the expected return.

Contract Investment ------------------------- = Exclusion Ratio Expected Return

The exclusion ratio is determined at the time annuity payments first begin (the “annuity starting date") and is applied to each payment as follows:

Exclusion Ratio x Annuity Payment = Amount Excluded From Taxable Income

The amount excluded from taxable income represents the portion of the annuity payment that is considered a return of capital. The remaining portion of the payment represents the taxable interest element.


Annuity starting date on or before December 31, 1986: If the annuity starting date was on or before December 31, 1986, the exclusion ratio remains constant throughout the annuitant’s lifetime. An annuitant who outlives his or her life expectancy will continue to exclude a portion of each payment from gross income even after recovering the full investment in the contract. Conversely, no deduction is allowed for the unrecovered investment of an annuitant who dies before recovering the investment in the contract.

Annuity starting date after December 31, 1986: If the annuity starting date is after December 31, 1986, the exclusion is limited to the investment in the contract. This means that the exclusion ratio will apply only until the total amount excluded equals the investment in the contract. After that, the full amount of each annuity payment is included in gross income. If the annuitant dies before recovering the investment in the contract, the unrecovered investment is deductible on the annuitant’s last income tax return.



Expected Return

Expected return (the denominator of the exclusion ratio) is the total amount the annuitant can expect to receive under the annuity contract. If payments are for a fixed period or a fixed amount with no life expectancy involved, expected return is the sum of the guaranteed payments.

If payments are to continue for a life or lives, expected return is determined by multiplying the sum of one year’s annuity payments by the life expectancy of the measuring life or lives using annuity tables prescribed by the IRS.

The expected return under an annuity contract is determined as of the "annuity starting date." The annuity starting date is defined as the "first day of the first period for which an amount is received as an annuity".



Investment in the Contract

The investment in the contract is determined as of the later of the annuity starting date or the date on which an amount is first received under the contract as an annuity.

The investment in the contract equals:

· the aggregate amount of premiums or other consideration paid for the contract,

· less amounts received under the contract that were excludable from gross income.

If the contract has a refund feature, the taxpayer must subtract the value of any refund payments from the investment in the contract.



Annuity Tables

The life expectancies used to determine expected returns are taken from annuity tables prescribed by the IRS. There are two sets of tables.

Tables I through IV (the "gender-based tables") are used for pre-July, 1986 investments and established separate return multiples for men and for women, with longer life expectancies for females.

Because of this distinction in the gender-based tables, a female could not exclude as high a proportion of an annuity payment as a male of the same age.



Tables V through VIII (the "unisex tables") are used for post-June 30, 1986 investments and do not distinguish between men and women.

Under the unisex tables, exclusion ratios for men and women of the same age will be identical.

However, because life expectancies increased between 1937 and 1983 (Tables I through IV are based on 1937 mortality data, Tables V through VIII are based on 1983 mortality data), both men and women will be taxed on a greater portion of annuity payments under the unisex tables.



The tables used to determine the expected return for a particular annuity will depend on (1) when the investment in the contract was made and (2) the annuity starting date.

While the IRS has detailed rules as to when to utilize each table, since you will mostly be dealing with annuity starting dates after June 30, 1986, you will be exposed primarily to unisex annuity tables.



An Example

To see how the exclusion ratio is affected by the use of unisex or gender-based tables, consider this example.

John Jones was age 61 (nearest birthday) when he bought an immediate life annuity in 1984. The single premium was $55,680 and the monthly annuity payments total $4,000 per year. Because the investment in the contract and the annuity starting date are before June 30, 1986, he can use the gender-based tables.

According to Table I, his life expectancy is 17.5 years. To find the portion of his annuity payment that is exempt from tax, he divides the investment ($55,680) by the expected return ($4,000 x 17.5, or $70,000). This quotient (.795 carried to three decimal places) is his exclusion ratio. He multiplies the exclusion ratio (.795) by the annual annuity payments ($4,000) to find the amount of each payment that is exempt from tax ($3,180). The balance of each year’s payments ($820) is taxable income.



Now let’s consider John’s brother Ben who is two years younger and who bought an identical annuity at age 61 after June 30, 1986.

The younger brother must use the unisex tables to calculate his exclusion ratio. According to Table V, his life expectancy is 23.3 years.

His exclusion ratio equals the investment in the contract ($55,680) divided by the expected return ($4,000 x 23.3, or $93,200), which equals .597.

The amount of each payment exempt from tax equals the exclusion ratio (.597) multiplied by the annual payments ($4,000), which is $2,388.

The balance of the payment received each year ($1,612) is taxable income – almost double the amount for John, who was able to use gender-based tables.



Dividends

Dividends received before the annuity starting date that were excluded from gross income represent return of capital, and since they reduce total investment in the contract, the effect is to lessen the tax-exempt fraction of the guaranteed annual payment.

On the other hand, dividends left on deposit as of the annuity starting date become part of the investment in the contract (the numerator of the exclusion ratio).



Disclaimer – Attachment II (Section 789 of CIC)

If a life agent offers to sell to a client any life insurance or annuity product, the life agent shall advise the client or the client’s agent in writing that the sales or liquidation of this product may have tax consequences.

The life agent shall disclose that the client may wish to consult independent legal counsel or financial advice before buying, selling or liquidating any assets being solicited or offered for sale.

This course is not intended to provide advise with issues surrounding income and estate taxation of annuities. If expert tax assistance is required, life agents shall advise client to consult with other professionals.


Lesson 8Advantages and Disadvantages of

Annuities


Advantages and Disadvantages

As with any insurance and financial services product, there are advantages and disadvantages with annuities. Even when considering the different types of annuities, there are pros and cons for each, especially when considering equity-indexed annuities. Since there is debate as to whether or not an equity-indexed annuity is more similar to a variable annuity than a fixed annuity, it’s helpful to compare them to fixed and variable annuities.

Before addressing the advantages and disadvantages of the different types of annuities, it’s important to consider the primary impact on those over age 60. The primary advantage to seniors is that an annuity is the only vehicle that can guarantee an income for life. This alleviates the concern that many senior citizens have about outliving their resources. The primary disadvantage for senior citizens is that annuities require a high level of funding and generally a longer-term accumulation phase to generate a desirable income stream. As such, many senior citizens will not be in a position to benefit from annuities.

Lesson 8: Advantages and Disadvantages

Advantages and Disadvantages


Fixed EIA Variable

Risk is borne by: Insurer Insurer Owner

Insurer creditor protection

No No Yes

Vesting schedules No Yes No

Annuitization options Yes Yes Yes

Surrender charges Yes Yes Yes

Ease of comparison with other annuities of the

same typeSimple Difficult Moderate

Level of complexity Low High Moderate

Licensing Insurance Insurance Insurance & Securities

Advantages of Fixed Annuities

Aside from the advantages of tax deferral offered with various types of annuities, a significant advantage of fixed annuities is that the annuity owner knows the applicable interest rate in advance. Even if the company has the right to change the interest rate on a monthly basis, the owner still knows the rate that will be credited. Some individuals find this gives them peace of mind, while others appreciate that having a portion of their funds in a fixed annuity offers a useful balance with the investment risk associated with other investments.

Another advantage of the fixed annuity is preservation of principal. Since a fixed annuity has a guaranteed rate of interest and no assumption of market risk, the annuity owner will not lose any of the premium amount, or principal, that is paid into the fixed annuity contract.


This can be valued by taxpayers who have a low risk tolerance overall and especially for taxpayers who are approaching retirement and will not have sufficient time to recover from any loss of principal.

With a fixed annuity, the benefits are paid out in a fixed amount when the annuity reaches the distribution phase. Some retirees take comfort in knowing that the amount of their annuity payout amount will remain stable – offering consistency and predictability.

Advantages of Fixed Annuities


Disadvantages of Fixed Annuities

The most significant disadvantage is likely that by locking in a fixed rate of interest, the annuity owner loses out on higher gains that could be realized if the same funds were invested in the stock market. Thus, for younger annuity owners and those with a greater risk tolerance, a fixed annuity may not be the most desirable choice. Or, it may be that placing only a portion of the annuity owner’s funds in a fixed annuity and investing the balance elsewhere may provide for higher overall returns.

Another disadvantage of fixed annuities is that the benefit amount will be fixed. While this can also be considered an advantage, it does not take inflation into account. The fixed benefit payout may not be as appealing at the end of a lengthy accumulation phase as it was at the time the fixed annuity was purchased.


Advantages of Variable Annuities

An advantage of variable annuities is that having the premiums allocated to various sub-accounts allows the annuity owner to track market returns and at least have the potential to keep pace with inflation. This also offers the potential for greater gains than may be realized with a fixed annuity. Also, since a variable annuity typically offers different risk profiles with the various sub-accounts, the annuity owner has the ability to move from a more aggressive allocation to a less aggressive one, perhaps as retirement approaches, all within the framework of the variable annuity contract.

Another advantage offered by variable annuities is the guaranteed death benefit. This is something generally no available with funds invested in the market through mutual funds or other means.


Disadvantages of Variable Annuities

Since the variable annuity owner assumes the investment risk associated with the sub-accounts selected, there is potential that the VA will earn lower rates than available with a fixed annuity. It’s also possible to lose money.

Another disadvantage is the fees associated with variable annuity contracts, which tend to be higher than those for fixed annuities.


Advantages of Equity-Indexed Annuities

One of the primary advantages of the equity-indexed annuity is that it allows a purchaser to participate in stock market index increases without completely giving up the principal and minimum interest rate guarantees available with traditional fixed annuities. In general terms, this means that an EIA owner will make money when the market rises but will not lose money when the market falls.

To individuals planning for retirement, the EIA offers the ability to earn a return that will keep pace with inflation without the necessity of risking the loss of the funds they have already accumulated. In an economic landscape where fixed annuities and certificates of deposit of deposit are paying fairly low interest rates, the ability to share in stock market gains with some limits on potential losses offered by EIAs looks attractive. In contract to variable annuities, the EIA owner does not have to monitor investment results and make decisions about how to allocate or reallocate premiums.


Disadvantages of Equity-Indexed Annuities

Many agree that the primary disadvantage of equity-indexed annuities is their complexity.

An individual considering the purchase of an EIA must understand a number of features and concepts (to be discussed in the next lesson) that do not come into play with a traditional fixed rate annuity.

Among these EIA-specific concepts are indexing, participation rates, vesting schedules, policy terms, and certain types of surrender charges.

This means, of course, that an agent selling an EIA must also be well-versed in these concepts and be able to explain to consumers what most will find a very complex product.


In addition to the complexity, it is also difficult to compare one equity-indexed annuity to another. Since different annuity companies utilize varying participation rates and indexing methods, simply comparing one number from each contract will not present an accurate illustration of the two contracts being compared.

Another potential disadvantage to an EIA may come to light if the owner decides to surrender the contract before the end of the contract term. Depending on the provisions of the specific EIA, the surrender may prove too costly.

Finally, unlike a variable annuity which is segregated into an account separate from the insurance company’s general assets, EIAs are typically considered to be obligations of the insurance company’s general account. This may cause concern for some purchasers as it does not protect the funds from the insurance company’s creditors.

Disadvantages of Equity-Indexed Annuities


Is an Annuity the Right Choice?

To find out if an annuity is right for a specific situation, think about what your client’s financial goals are for the future. Analyze the amount of money the client is willing to invest in an annuity, as well as how much of a monetary risk the client is willing and able to take. An annuity should not be purchased to reach short-term financial goals, which makes the agent’s role in presenting them to those over age 60 particularly important.

When determining whether an annuity is the best option, the following questions should be asked:

· How much retirement income will be needed in addition to what the client will get from Social Security and other pension plans?

· Will supplementary income be needed for others in addition to the client?


· How long does the client plan on leaving money in the annuity?

· When does the client plan on needing income payments?

· Will the annuity allow the client to gain access to the money when needed?

· Does the client want a fixed annuity with a guaranteed interest rate and little or no risk of losing the principal?

· Does the client want a variable annuity with the potential for higher earnings that aren't guaranteed and the possibility for the risk of loss of principal?

· Or, is the client somewhere in between and willing to take some risks with an equity-indexed annuity?

Is an Annuity the Right Choice?


Alternatives to Annuities

In addition to the other retirement planning vehicles discussed earlier in this course (IRAs, qualified retirement plans, and TSAs), some of the other financial tools that can be used to accumulate funds for some future purpose include bank savings accounts, certificates of deposit, and mutual funds.


Bank Savings Account

A savings account at a bank, savings and loan, or a credit union is simply an account that holds money for the depositor.

Periodically, the bank credits interest at a pre-determined rate on the funds in the account.

A true savings account does not offer any check-writing privileges.

A savings account is generally considered a safe place to keep funds, because banks do not usually invest in financial arrangements that carry a large degree of risk.

In addition, deposits in many banks are insured by the Federal Deposit Insurance Corporation (FDIC) or a similar state institution.


Although a savings account is a low-risk financial vehicle allowing easy access to funds without penalty, interest earned on the savings account funds is taxed to the account holder at the time it is earned.

The savings account does not allow deferral of the tax until the funds are withdrawn, as does the nonqualified annuity.

From a financial planning perspective, placing funds in an annuity to the exclusion of placing funds in a vehicle such as a savings account that offers immediate and penalty-free access to the funds is not a recommended course of action.

Many financial planners counsel their clients to keep an “emergency fund” equal to three to six months’ income in a savings-account type of fund.

The emergency fund should be well-established before funds are channeled into less accessible vehicles such as annuities.

Bank Savings Account


Certificates of Deposit

In contrast to the easy accessibility of a savings account, funds placed in a certificate of deposit, or CD, are available only at maturity without penalty.

A CD is a vehicle, offered by a financial institution, into which an individual places funds for a certain length of time and, in return, receives interest at a set rate.

The interest rate is usually higher than the rate of interest paid on a savings account and, often, the financial institution will require a minimum amount to purchase a CD.

If a CD holder wishes to withdraw all or a portion of the CD funds prior to the end of the CD period, usually a certain portion of the interest earned on the funds will be forfeited to the bank.


Most banks and other institutions offer CDs for various lengths of time and, usually, the longer the time frame, the higher the interest rate that the CD holder will receive on his money.

From an income tax perspective, CDs are taxed like savings accounts. The interest earned is taxed in the year in which it is credited to the CD.

Certificates of Deposit


Mutual Funds

A mutual fund operates as a pool into which investors may place their funds. The mutual fund issues each investor a certain number of shares according to the amount of his investment.

Then the mutual fund invests all the funds from all its investors in various investment vehicles available in the financial marketplace.

By pooling their funds, the investors in a mutual fund create a much larger amount of money to invest than any single investor could muster.

This allows the mutual fund to diversify its investments to a much greater extent than could a lone investor and, thus, lessen the risk to all investors.


There are many different types of mutual funds, some investing in only one type of investment such as growth stocks, some investing in a single industry such as health care and some offering a “family” of funds each with a different emphasis.

Most funds, known as open-ended funds, will buy an investor’s shares in the fund back at any time, making this type of investment a fairly liquid one.

Many funds charge investors a fee which consists of a stated percentage of each investor’s account, a flat fee, or both. There are a significant number of funds that do not charge sales fees, called “no-load” funds. “Load” is another term used to describe a sales fee.

Returns from a mutual fund must be reported as taxable income by the investor currently. There is no income tax deferral offered by most mutual funds.

Mutual Funds


Comparison Chart

The following chart illustrates the advantages and disadvantages of a wide range of investment alternatives.


Type of Investment

Average Yield/ Risk

Liquidity FeesEarly

Withdrawal Penalties

Tax Deferred Earnings

Payout Flexibility

Fixed Annuities Low Med Yes Yes Yes High

Variable Annuities Med Med Yes Yes Yes High

Equity Indexed Annuities

Med Low Yes Yes Yes High

CDs Low Med No Yes No Low

Money Markets Med Low Yes Yes No No

Savings Accounts Low High No No No No

Mutual Funds High Med Yes Yes Yes No

Type of Investment

Average Yield/ Risk

Liquidity FeesEarly

Withdrawal Penalties

Tax Deferred Earnings

Payout Flexibility

Stocks High Med Yes No Yes No

Bonds Low Low Yes Yes Yes No

Commodities High Med Yes No No No

Options High Med Yes No No No

Limited Partnerships

High Low Yes N/A Yes No

Promissory Notes Med Low No N/A Yes No

Real Estate Investment Trusts

Med Low Yes N/A Yes No

Viatical Settlements

Low High Yes Yes No No

Comparison Chart


Lesson 9Sales Practices for California

Insurance Agents


Obligations of Producer at Contract Inception

Disclosure

Section 789.8 of the California Insurance Code applies to “elders” or those residing in the state who are age 65 or older.

If a life agent offers to sell annuities to elders, he must advise in writing that the sale or liquidation of any stock, bond, IRA, certificate of deposit, mutual fund, annuity, or other asset to fund the annuity purchase may have tax consequences and that independent legal or financial advice may be desired prior to completion of the transaction.

When dealing with the treatment of a product under the Medi-Cal program, the agent may not negligently misrepresent the treatment of any asset under the statutes, rules and regulations of the Medi-Cal program, as it pertains to the determination of eligibility for any program of public assistance.

Lesson 9: California Sales Practices

In these situations, the agent shall provide the following disclosure to the elder or the elder’s agent:

"NOTICE REGARDING STANDARDS FOR MEDI-CAL ELIGIBILITY AND RECOVERY

If you or your spouse are considering purchasing a financial product based on its treatment under the Medi-Cal program, read this important message!

You or your spouse do not have to use up all of your savings before applying for Medi-Cal.

RECOVERY

An annuity purchased on or after September 1, 2004, shall be subject to recovery by the state upon the annuitant's death under the regulations of the Medi-Cal Recovery Program. Income derived from the annuity must be used to meet the annuitant's share of costs and, if the annuitant is married, the income derived from the annuity may impact the minimum monthly maintenance needs of the annuitant's community spouse. An annuity purchased by a community spouse on or after September 1, 2004, may also be subject to recovery if that spouse is the recipient of past or future Medi-Cal benefits.

Disclosure


UNMARRIED RESIDENT

An unmarried resident may be eligible for Medi-Cal benefits if he or she has less than (insert amount of individual's resource allowance) in countable resources.

The Medi-Cal recipient is allowed to keep from his or her monthly income a personal allowance of (insert amount of personal needs allowance) plus the amount of any health insurance premiums paid. The remainder of the monthly income is paid to the nursing facility as a monthly share of cost.

Disclosure


MARRIED RESIDENT

COMMUNITY SPOUSE RESOURCE ALLOWANCE: If one spouse lives in a nursing facility, and the other spouse does not live in a facility, the Medi-Cal program will pay some or all of the nursing facility costs as long as the couple together does not have more than (insert amount of community countable assets).

MINIMUM MONTHLY MAINTENANCE NEEDS ALLOWANCE: If a spouse is eligible for Medi-Cal payment of nursing facility costs, the spouse living at home is allowed to keep a monthly income of at least his or her individual monthly income or (insert amount of the minimum monthly maintenance needs allowance), whichever is greater.

Disclosure


FAIR HEARINGS AND COURT ORDERS

Under certain circumstances, an at-home spouse can obtain an order from an administrative law judge or court that will allow the at-home spouse to retain additional resources or income. The order may allow the couple to retain more than (insert amount of community spouse resource allowance plus individual's resource allowance) in countable resources. The order also may allow the at-home spouse to retain more than (insert amount of the monthly maintenance needs allowance) in monthly income.

Disclosure


REAL AND PERSONAL PROPERTY EXEMPTIONS

Many of your assets may already be exempt. Exempt means that the assets are not counted when determining eligibility for Medi-Cal.

REAL PROPERTY EXEMPTIONS

ONE PRINCIPAL RESIDENCE: One property used as a home is exempt. The home will remain exempt in determining eligibility if the applicant intends to return home someday.

The home also continues to be exempt if the applicant's spouse or dependent relative continues to live in it.

Money received from the sale of a home can be exempt for up to six months if the money is going to be used for the purchase of another home.

REAL PROPERTY USED IN A BUSINESS OR TRADE: Real estate used in a trade or business is exempt regardless of its equity value and whether it produces income.

Disclosure


PERSONAL PROPERTY AND OTHER EXEMPT ASSETS

· IRAs, KEOGHs, AND OTHER WORK-RELATED PENSION PLANS: These funds are exempt if the family member whose name it is in does not want Medi-Cal. If held in the name of a person who wants Medi-Cal and payments of principal and interest are being received, the balance is considered unavailable and is not counted. It is not necessary to annuitize, convert to an annuity, or otherwise change the form of the assets in order for them to be unavailable.

· PERSONAL PROPERTY USED IN A TRADE OR BUSINESS.

· ONE MOTOR VEHICLE.

· IRREVOCABLE BURIAL TRUSTS OR IRREVOCABLE PREPAID BURIAL CONTRACTS.

· THERE MAY BE OTHER ASSETS THAT MAY BE EXEMPT.

Disclosure


This is only a brief description of the Medi-Cal eligibility rules. For more detailed information, you should call your county welfare department. Also, you are advised to contact a legal services program for seniors or an attorney who is not connected with the sale of this product.

I have read the above notice and have received a copy.

Dated: _______________ Signature: ________________"

Disclosure


The statement required in this subdivision shall be printed in at least 12-point type, shall be clearly separate from any other document or writing, and shall be signed by the prospective purchaser and that person's spouse, and legal representative, if any.

The State Department of Health Services shall update this form to ensure consistency with state and federal law and make the disclosure available to agents and brokers through its Internet Web site.

Nothing in this section allows or is intended to allow the unlawful practice of law.

Disclosure


Illustrations

Under CIC Section 1725.5, every licensee must show his license number(s) n the same size type as phone number and address on business cards, written price quotations and print advertisements for insurance products. For those working as exclusive employees of motor clubs, organizational licensee numbers shall be used. He must also include the word “Insurance” in type no smaller than the largest indicated telephone number.

Any person in violation of this section shall be subject to a fine levied by the commissioner in the amount of $200 for the first offense, $500 for the second offense, and $1,000 for the third and subsequent offenses.


Non-preprinted illustrations of nonguaranteed values shall disclose on the illustration or on an attached cover sheet, in bold or underlined capitalized print, or in the form of a contrasting color sticker, bright highlighter pen, or in any manner that makes it more prominent than the surrounding material, with at least one-half inch space on all four sides, the following statement:

THIS IS AN ILLUSTRATION ONLY. AN ILLUSTRATION IS NOT INTENDED TO PREDICT ACTUAL PERFORMANCE. INTEREST RATES, DIVIDENDS, OR VALUES THAT ARE SET FORTH IN THE ILLUSTRATION ARE NOT GUARANTEED, EXCEPT FOR THOSE ITEMS CLEARLY LABELED AS GUARANTEED.

Illustrations


All preprinted policy illustrations must contain this notice on the illustration form itself or on an attached cover sheet in 12-point bold print with at least one-half inch space on all four sides and shall be printed, or on a contrasting color sticker placed on the front of the illustration. All preprinted illustrations containing nonguaranteed values shall show the columns of guaranteed values in bold print. All other columns used in the illustration shall be in standard print. "Values" as used here includes cash value, surrender value, and death benefit.

Illustrations


Replacement

Per Sections 10509.4 and 10509.8 of the CIC, the agent must submit to the insurer with the application to the annuity both of the following:

1. A statement signed by the applicant as to whether replacement of existing life insurance or annuity is involved in the transaction.

2. A signed statement as to whether or not the agent knows replacement is or may be involved in the transaction.


Where a replacement is involved, the agent shall do all of the following:

· Present to the applicant, not later than at the time of taking the application, a "Notice Regarding Replacement of Life Insurance" in the form as described in subdivision (d). The notice shall be signed by both the applicant and the agent and left with the applicant. Obtain with or as part of each application a list of all existing life insurance or annuities to be replaced and properly identified by name of insurer, the insured and contract number. If a contract number has not been assigned by the existing insurer, alternative identification, such as an application or receipt number, shall be listed.

· Leave with the applicant the original or a copy of all printed communications used for presentation to the applicant.

· Submit to the replacing insurer with the application a copy of the replacement notice.

Replacement


NOTICE REGARDING REPLACEMENT

REPLACING YOUR LIFE INSURANCE POLICY OR ANNUITY?

Are you thinking about buying a new life insurance policy or annuity and discontinuing or changing an existing one? If you are, your decision could be a good one—or a mistake. You will not know for sure unless you make a careful comparison of your existing benefits and the proposed benefits.

Make sure you understand the facts. You should ask the company or agent that sold you your existing policy to give you information about it.

Hear both sides before you decide. This way you can be sure you are making a decision that is in your best interest.

We are required by law to notify your existing company that you may be replacing their policy.

___________________ _______________ ______________(applicant) (agent) (date)

Replacement


A violation shall occur if an agent or insurer recommends the replacement or conservation of an existing policy by use of a materially inaccurate presentation or comparison of an existing contract's premiums and benefits or dividends and values, if any, or recommends that an insured 65 years of age or older purchase an unnecessary replacement annuity.

For purposes of this section, "unnecessary replacement" means the sale of an annuity to replace an existing annuity that requires that the insured will pay a surrender charge for the annuity that is being replaced and that does not confer a substantial financial benefit over the life of the policy to the purchaser so that a reasonable person would believe that the purchase is unnecessary.

Replacement


Patterns of action by policyowners who purchase replacement policies from the same agent after indicating on applications that replacement is not involved, shall constitute a rebuttable presumption of the agent's knowledge that replacement was intended in connection with the sale of those policies, and such patterns of action shall constitute a rebuttable presumption of the agent's intent to violate this article.

This article does not prohibit the use of additional material other than that which is required that is not in violation of this article or any other statute or regulation.

Replacement


Free Look Period

As outlined under Sections 786 and 10127.10 of the CIC, annuities offered for sale to individuals age 65 or older in California shall provide an examination period of 30 days after the receipt of the policy or certificate for purposes of review of the contract, at which time the applicant may return the contract.

The return shall void the policy or certificate from the beginning, and the parties shall be in the same position as if no contract had been issued.

All premiums paid and any policy or membership fee shall be fully refunded to the applicant by the insurer or entity in a timely manner.


Timely manner shall be no later than 30 days after the insurer or entity issuing the policy or certificate receives the returned policy or certificate. If the refund of the premiums paid is not made in a timely manner, then the applicant shall receive interest on the paid premium at the legal rate of interest on judgments as provided in Section 685.010 of the Code of Civil Procedure. The interest shall be paid from the date the insurer or entity received the returned policy or certificate.

Each policy or certificate shall have a notice prominently printed in no less than 10-point uppercase type, on the cover page of the policy or certificate and the outline of coverage, stating that the applicant has the right to return the policy or certificate within 30 days after its receipt via regular mail, and to have the full premium refunded.

Free Look Period


Every individual annuity contract issued for delivery shall have the following notice either printed on the cover page or policy jacket in 12-point bold print with one inch of space on all sides or printed on a sticker that is affixed to the cover page or policy jacket:

"IMPORTANT YOU HAVE PURCHASED A LIFE INSURANCE POLICY OR ANNUITY CONTRACT. CAREFULLY REVIEW IT FOR LIMITATIONS.

THIS POLICY MAY BE RETURNED WITHIN 30 DAYS FROM THE DATE YOU RECEIVED IT FOR A FULL REFUND BY RETURNING IT TO THE INSURANCE COMPANY OR AGENT WHO SOLD YOU THIS POLICY. AFTER 30 DAYS, CANCELLATION MAY RESULT IN A SUBSTANTIAL PENALTY, KNOWN AS A SURRENDER CHARGE."

Free Look Period


Reviewing Sample Contracts

In the annuity contract, the roles of the insurer and the agent are indistinguishable.

However, as the agent is the representative of the insurer to the applicant, it is important that the agent review all sample contracts and other materials provided by the insurer before presenting them to an applicant.

The agent is the “last line of defense” and therefore assumes the greater burden of responsibility for ensuring that all aspects of the annuity sale are conducting in accordance with applicable regulations.


Appropriate Advertising – General Advertising

Insurance company advertising must adhere to specific guidelines, particularly when designed to obtain leads of persons age 65 or older.

Regulations regarding “advertisements” also apply to envelopes, stationery, business cards, or other materials designed to describe and encourage the purchase of a policy or certificate of disability insurance, life insurance, or an annuity.

As previously discussed, the agent’s license number and the word “Insurance” must be included on materials and must be prominently displayed on all materials used for seminars, classes, informational meetings, and direct mailers.

It is the responsibility of the insurance company to approve the use of advertising before it is used by agents, producers, brokers, solicitors, or other persons for a policy of an insurer. This approval must be in writing.


Advertisements shall not employ words, letters, initials, symbols, or other devices which are so similar to those used by governmental agencies, a nonprofit or charitable institution, senior organization, or other insurer that they could have the capacity or tendency to mislead the public. Examples of misleading materials, include, but are not limited to, those which imply any of the following:

· The advertised coverages are somehow provided by or are endorsed by any governmental agencies, nonprofit or charitable institution or senior organizations.

· The advertiser is the same as, is connected with, or is endorsed by governmental agencies, nonprofit or charitable institutions or senior organizations.



These guidelines do not apply to any person or entity that is not currently required to be licensed by the department or that is exempted from licensure.

Nor do they apply to general advertisements of motor clubs that merely list insurance products as one of several services offered but do not provide any details of the insurance products.

These requirements also do not apply to nonresident agents representing an insurer that is a directresponse provider.



For the purposes of this section, "direct response provider" means an insurer that meets each of the following criteria:

· The insurer does not initiate telephone contact with insureds or prospective insureds

· .Agents of the insurer speak with insureds and prospective insureds only by telephone, and at the request of the insureds or prospective insureds.

· Agents of the insurer are assigned to speak with insureds or prospective insureds on a random basis, when contacted.

· Agents of the insurer are salaried and do not receive commissions for sales or referrals.



Any applicable person in violation of these regulations shall be subject to a fine levied by the commissioner in the amount of two hundred dollars ($200) for the first offense, five hundred dollars ($500) for the second offense, and one thousand dollars ($1,000) for the third and subsequent offenses.

The penalty shall not exceed one thousand dollars ($1,000) for any one offense. These fines shall be deposited into the Insurance Fund.

A separate penalty shall not be imposed upon each piece of printed material that fails to conform to the requirements of this section.



Any advertisement or other device designed to produce leads based on a response from a potential insured which is directed towards persons age 65 or older shall prominently disclose that an agent may contact the applicant if that is the fact.

In addition, an agent who makes contact with a person as a result of acquiring that person's name from a lead generating device shall disclose that fact in the initial contact with the person.

No insurer, agent, broker, solicitor, or other person or other entity shall solicit persons age 65 and older in this state for the purchase of disability insurance, life insurance, or annuities through the use of a true or fictitious name which is deceptive or misleading with regard to the status, character, or proprietary or representative capacity of the entity or person, or to the true purpose of the advertisement.

Appropriate Advertising – Specific Advertising to Seniors


Prohibited Sales Practices

Agents selling annuities in California must be careful to avoid certain sales practices, particularly when selling to individuals who are age 60 or older.

As with regulations regarding marketing practices, the rules are in place to ensure that annuity sellers fulfill their duty to represent their products with honesty, good faith and fair dealing.

Again, significant fines have been established for violations of these regulations, so it’s extremely important that agents be familiar with them.


Selling Annuities for Medi-Cal Eligibility

It’s prohibited to sell annuities to persons age 60 or older for the purpose of obtaining eligibility for Medi-Cal if the individual’s assets or equal to or less than the community spouse resource allowance, if the senior would otherwise qualify, or if after the purchase the senior or spouse would not qualify.

It is permitted to sell annuities in an effort to qualify for Medi-Cal eligibility if neither of those situations applies.

According to section 789.8 of the CIC, when selling annuities on the basis of the Medi-Cal program, the agent must provide a written disclosure to the individual describing Medi-Cal eligibility rules. These disclosures were provided at the beginning of this lesson.


In-Home Solicitations

Agents selling life insurance or annuities must provide a written notice at least 24 hours in advance of a meeting in a senior’s home clearly informing the individual of the purpose of the meeting.

If the individual is in response to a current client’s request for an appointment the same day, this notice must be presented as the appointment begins.

The agent is also prohibited from setting up an in-home meeting under disguised means. The true meaning behind the meeting must be clearly expressed.


The notice must be in 14-point type, in a form similar to the example below.

1. During this visit or a follow-up visit, you will be given a sales presentation on the following (indicate which apply):

( ) Life insurance, including annuities

( ) Other insurance products (specify): _________________.

2. You have the right to have other persons present at the meeting, including family members, financial advisors or attorneys.

3. You have the right to end the meeting at any time.

4. You have the right to contact the Department of Insurance for information, or to file a complaint. (The notice shall include the consumer assistance telephone numbers at the department)

5. The following individuals will be coming to your home: (list all attendees, and insurance license information, if applicable)

In-Home Solicitations


Sharing Commissions with Attorneys

Agents are prohibited from sharing sales commissions or other monetary considerations with attorneys relating to the sale or renewal of an annuity or insurance policy, unless the agent is an active member of the State Bar of California.

This regulation recognizes the sensitive role that attorneys perform for their clients.

While attorneys often will refer their clients to financial representatives for specialized needs, receiving compensation for doing so would obviously represent a conflict of interest and a breach of the trust placed in the attorney by his or her client.


Unnecessary Replacement

The complex terms and charges that are associated with annuities require that the agent be careful not to recommend to individuals age 65 or older the replacement of an existing annuity with another if the replacement does not provide a substantial benefit over the life of the contract to the purchaser. The financial benefit must be such that a “reasonable person” would consider it to be “substantial” if informed of the entire details of the transaction.

For this reason it is especially prohibited to use materials that show only part of the overall picture, for example an illustration that shows that the individual would receive a higher interest rate, but that fails to factor in the payment of surrender charges associated with the annuity being replaced. Remember also that specific advertising regulations apply whenever representing an annuity or life insurance policy as a replacement to an existing annuity or policy.


Bait and Switch

The term “bait and switch” is usually associated with retail stores. The classic scenario advertising of a product at a ridiculously low price (the “bait”) with the intention of actually selling a much more profitable item to customers who arrive at the store (the “switch”) once they find that the advertised item is “sold out.”

In annuity sales, the term refers to representing an interview with prospects in an attractive-sounding way, while the agent’s real goal is something else.

For example, an agent meets with a prospect and discusses a number of investment choices, recommending a “variable annuity” as the best option. The agent mentions that there are a few medical “tests” which are simply standard procedure, but never mentions the word “insurance,” instead promising the prospect a “guaranteed” future value of the investment.


Instead, the agent sells the prospect a variable life insurance policy, with no discussion of the differences between variable life insurance and a variable annuity, including the fact that pulling any money out of a variable life policy is in fact a policy loan.

Another example of an annuity “bait and switch” is the trust mill, a scheme in which companies “sell” expensive boilerplate estate planning documents that seem to have been prepared by attorneys but in fact have not. There are several variations on the scheme, but all of them share one common thread: a misrepresentation of the true purpose of why the agent wants to talk to the individual.

Bait and Switch


Trust mills operate under many different names and mainly target seniors, using the confidential financial information they obtain to also sell clients on inappropriate investments. Clients are told that they should not see an attorney about the estate plan or investments as the attorney probably won’t “understand.”

In many cases insurance agents misrepresent themselves as legal experts, engaging in illegal practices such as delivering and interpreting legal documents without a law license.

Companies such as the National Trust Service, Alliance for Mature Americans, Legacy Legal, Estate Protection Planning Corporation, and Senior Informational Services have all been exposed as trust mills.

Bait and Switch


The trust mill scheme has resulted in stronger laws targeting such practices.

Pretext interviews are specifically prohibited in association with any insurance-related transaction.

A pretext interview is one in which an agent engages in any of the following while attempting to obtain information:

a. Pretend to be someone he or she is not.

b. Pretend to represent a person who is in fact not being represented.

c. Misrepresent the true purpose of an interview.

d. Refuse to identify him or herself when asked to do so.

Bait and Switch


Section 6125 of the California Business and Professions Code prohibits anyone from practicing law in the state unless that person is an active member of the state bar. Individuals who are not active members of the state bar may not draft, deliver, or interpret legal documents in the process of selling annuity contracts.

Bait and Switch


Cause for Suspension

The following acts shall constitute cause to suspend or revoke any permanent license issued pursuant to prohibited sales practices:

a) The licensee has induced a client, whether directly or indirectly, to cosign or make a loan, make an investment, make a gift, including a testamentary gift, or provide any future benefit through a right of survivorship to the licensee, or to any of the persons listed in subdivision (e).

b) The licensee has induced a client, whether directly or indirectly, to make the licensee or any of the persons listed in subdivision (e) a beneficiary under the terms of any intervivos or testamentary trust or the owner or beneficiary of a life insurance policy or an annuity policy.


c) The licensee has induced a client, whether directly or indirectly, to make the licensee, or a person who is registered as a domestic partner of the licensee, or is related to the licensee by birth, marriage, or adoption, a trustee under the terms of any intervivos or testamentary trust. However, if the licensee is also licensed as an attorney in any state, the licensee may be made a trustee under the terms of any intervivos or testamentary trust, provided that the licensee is not a seller of insurance to the trustor of the trust.

d) The licensee, who has a power of attorney for a client has sold to the client or has used the power of attorney to purchase an insurance product on behalf of the client for which the licensee has received a commission.



e) Subdivisions (a) and (b) shall also apply if the licensee induces the client to provide the benefits in those subdivisions to the following people:

(1) A person who is related to the licensee by birth, marriage, or adoption.

(2) A person who is a friend or business acquaintance of the licensee.

(3) A person who is registered as a domestic partner of the licensee.

f) This section shall not apply to situations in which the client is:

(1) A person related to the licensee by birth, marriage, or adoption.

(2) A person who is registered as a domestic partner of the licensee.



Penalties

Penalties for Prohibited Sales Practices

Penalties for prohibited sales practices: Penalties can be severe for companies and agents found to be in violation of California insurance regulations. The specific penalties for prohibited sales practices listed below are in addition to any court-ordered damages and restitution that violators may face.

Penalties for advertising practices violations: for brokers and agents - $1,000 administrative penalty for first violation; $5,000 - $50,000 for subsequent “knowing violations;” license suspension if actions are found to cause ‘significant harm’ to seniors; for insurers - $10,000 administrative penalty for first violation; $30,000 to $300,000 penalty for subsequent “knowing violations” or business practices in violation of the article.


Penalties for Medi-Cal eligibility violations: Brokers and agents - $1,000 administrative penalty for first violation; $5,000 - $50,000 for subsequent “knowing violations;” license suspension if actions are found to cause ‘significant harm’ to seniors; Insurers - $10,000 administrative penalty for first violation; $30,000 to $300,000 penalty for subsequent “knowing violations” or business practices in violation of the article; rescission of policies sold in violation of regulations.

Penalties for in-home solicitation violations: Brokers and agents - $1,000 administrative penalty for first violation; $5,000 - $50,000 for subsequent “knowing violations;” license suspension if actions are found to cause ‘significant harm’ to seniors; Insurers - $10,000 administrative penalty for first violation; $30,000 to $300,000 penalty for subsequent “knowing violations” or business practices in violation of the article.

Penalties


Penalties for sharing commissions with attorney: Brokers and agents - $200 fine for the first offense; $500 for the second offense; and $1,000 for the third and subsequent offenses.

Penalties for unnecessary replacement violations: Brokers and agents - $1,000 administrative penalty for first violation; $5,000 - $50,000 for subsequent “knowing violations;” license suspension if actions are found to cause ‘significant harm’ to seniors; Insurers - $10,000 administrative penalty for first violation; $30,000 to $300,000 penalty for subsequent “knowing violations” or business practices in violation of the article.

Penalties


Penalties for policy misrepresentation, bait and switch, pre-text interview violations: any involved individual: Up to $1,500 and up to 6 months imprisonment; possible license suspension or, in the case of an insurer, revocation of certificate of authority to issue class of involved insurance; proceedings in case of violations against persons 65 age or older are held within 90 days after notification, which may result in revocation of an organization’s permanent license as well as the suspension or revocation of any member of the organization; additional fines of $4,000 per offense ($20,000 total) and up to 30% of gross commissions earned in the previous calendar year may also be assessed at the discretion of the commissioner.

Penalties


SB 483, Kuehl. Medi-Cal Home and Facility Care

Agents must be aware of, and may not represent, areas addressed under SB 483, Kuehl. Medi-Cal Home and Facility Care, including guidelines for home equity limits, hardship exceptions, look-back periods, and requirements related to annuities, designated beneficiaries, and California’s role as a remainder beneficiary of annuities.

Home Equity Limits, Section 14006.15 of the Welfare and Institutions Code:

For the purposes of this section, "equity interest" means the lesser of the following:

1. The assessed value of the principal residence determined under the most recent tax assessment, less any encumbrances of record.

2. The appraised value of the principal residence determined by a qualified real estate appraiser who has been retained by the applicant or beneficiary, less any encumbrances of record.


An individual is not eligible for medical assistance for home and facility care if his or her equity interest in the principal residence exceeds $750,000. No later than December 31, 2011, and each year thereafter, this amount shall be increased based on the percentage increase in the consumer price index for all urban consumers (all items, United States city average), rounded to the $1,000.

This section does not apply to an individual if any of the following circumstances exist:

1. The spouse of the individual or the individual's child, who is under 21 years of age, or who is blind or who is disabled, and is lawfully residing in the individual's home.

2. The individual was determined eligible for medical assistance for home and facility care based on an application filed before January 1, 2006.



3. The department determines that ineligibility for medical assistance for home and facility care would result in demonstrated hardship on the individual. For purposes of this section, demonstrated hardship shall include, but need not be limited to, any of the following circumstances:

a) The individual was receiving home and facility care prior to January 1, 2006.

b) The individual has been determined to be eligible for medical assistance for home and facility care based on an application filed on or after January 1, 2006, and before the date that regulations adopted pursuant to this section are certified with the Secretary of State.

c) The individual purchased and received benefits under a long-term care insurance policy certified by the department's California Partnership for Long-Term Care Program.



d) The individual's equity interest in the principal residence exceeds the equity interest described previously but would not exceed the equity interest limit under that subdivision if it had been increased by using the quarterly House Price Index (HPI) for California, published by the Office of Federal Housing Enterprise Oversight (OFHEO).

e) The applicant or beneficiary has been denied a home equity loan by at least three lending institutions, or is ineligible for any one Federal Housing Administration (FHA) approved loan or reverse mortgage.

f) The applicant or beneficiary, with good cause, is unable to provide verification of the equity value.



Hardship Exceptions, Sections 14015.1 and 14015.2 of the Welfare and Institutions Code: No person shall be subject to a period of ineligibility for medical assistance for home and facility care at the time of the initial application or redetermination if the department determines that an undue hardship exists. An undue hardship shall be found to exist under any of the following circumstances:

1. The individual has been determined eligible for medical assistance for home and facility care based on an application filed on or after January 1, 2006, and before the date that regulations adopted pursuant or relating to this section have been certified with the Secretary of State.

2. The deprivation of medical assistance for home and facility care would cause an endangerment to the life or health of the individual.



3. The denial of medical assistance for home and facility care would result in the eviction of the individual from a nursing home.

4. The individual is otherwise eligible for the Medi-Cal program and unable to obtain home and facility care without Medi-Cal.

5. The denial of medical assistance for home and facility care would cause the individual to be unable to remain at home or in the community and would hasten or cause the individual's entry into a medical or long-term care institution.

6. The individual would be deprived of food, clothing, shelter, or other necessities of life.



In addition, in accordance with Section 1917(c)(2)(D) of the federal Social Security Act (42 U.S.C. Sec. 1396p(c)(2)(D)), any of the following may request a fair hearing on the issue of undue hardship:

1. An individual requesting or receiving medical assistance for home and facility care.

2. A personal representative of an individual requesting or receiving medical assistance for home and facility care.

3. The facility in which the individual requesting or receiving medical assistance for home and facility care is residing, with the consent of that individual or the personal representative of that individual.

An individual with a pending undue hardship appeal who is subject to a period of ineligibility pursuant to this article shall receive medical assistance for home and facility care for a maximum of 30 bed-hold days.



Look-back period, Section 14015[c] of the Welfare and Institutions Code: it shall be presumed that assets transferred by the applicant or beneficiary prior to the look-back period established by the department preceding the date of initial application were not transferred to establish eligibility or reduce the share of cost. These assets shall not be considered in determining eligibility.



The state as a remainder beneficiary, Sections 14006.15[a][2], 14006.41[b], 14009.6 of Welfare and Institutions Code: At the time of the individual's application or redetermination, the department shall inform the individual and his or her spouse that, by virtue of its provision of medical assistance for home and facility care to the individual, the state will, by operation of law, become a remainder beneficiary of certain annuities.

As a result of providing medical assistance for home and facility care to an individual, the state shall become a remainder beneficiary of annuities purchased by the individual or his spouse in which the individual or spouse is an annuitant. An exception exists if the individual or spouse notifies the department in writing that he prohibits the state from acquiring a remainder interest in the annuity. In this situation, the purchase of the annuity shall be treated as the transfer of an asset for less than fair-market value.



This section applies only to the following annuities:

· Those purchased on or after February 8, 2006.

· Those purchased before February 8, 2006, and subjected to a transaction that occurred on or after February 8, 2006. A “transaction” includes any action taken that changes the course of payments to be made by the annuity or the treatment of the income or principal of the annuity. “Transactions” do not include:

Routine changes and automatic events that do not require any action or decision on or after February 8, 2006.

Changes that occur based on the terms of the annuity that existed prior to February 8, 2006, and that do not require a decision, election, or action to take effect.

Changes that are beyond the control of the individual or the individual's spouse.



The Importance of Determining Client Suitability

Although they may be most at risk, it’s not just important that annuities are suitable for senior clients.

A primary consideration when marketing annuities is to ensure these products are appropriate for each client’s age, risk tolerance and understanding of the product being offered.

For the consumer, it is important that the producer explain their qualifications and thoroughly explain all contract provisions and how they affect the consumer, as explained throughout this course.


In 2003 the National Association of Insurance Commissions adopted the Senior Protection in Annuity Transactions Model Regulation, designed to help protect seniors when they purchase or exchange annuity products.

The regulation requires that an insurance agent have reasonable grounds for believing that the recommendation to buy or exchange an annuity is suitable for a senior consumer based on facts disclosed by the senior consumer as to his or her investments, other insurance products and financial situation and needs.

In other words, the agent is expected to gain detailed facts before recommending an annuity product for seniors, and the recommendation must meet the reasonableness standard based on the information uncovered.



However, these regulations do not apply if an individual refuses to provide information despite a request by the insurer or agent, or decides to enter into an insurance transaction without a recommendation by the insurer or agent, or fails to provide complete or accurate information.

In such cases the reasonableness criteria will apply only to the information actually known to the insurer or agent at the time of the recommendation.

When variable annuities are proposed, agents must meet the additional requirements of the NASD suitability rule, which requires that they recommend a securities transaction to a customer only if the recommendation suits the customer’s investment portfolio.



Suitability Information

The insurance agent must make every effort to gather the necessary information to determine the products that are suitable for a client’s current and future circumstances. Once you have established the products that are appropriate, you will be guided by experience and training in making your final recommendation.

Among the information about the client that will assist the producer in determining that a transaction is suitable is:

· Age

· Annual income

· Financial situation and needs, including the financial resources used for the funding of the annuity

· Existence of comprehensive long-term care insurance

· Financial experience


· Financial and investment objectives

· Intended use of the annuity

· Financial time horizon

· Existing assets, including investment and life insurance holdings

· Liquidity needs

· Liquid net worth

· Risk tolerance

· Tax status

Suitability Information


NAIC Suggested Questions When Considering Annuity

The questions listed below may help a client decide which type of annuity, if any, meets their retirement planning and financial needs. An individual should consider what their goals are for the money put into the annuity and think about how much risk they’re willing to take with the money. The agent should help the client answer these questions about themselves:

· How long can I leave my money in the annuity?

· What do I expect to use the money for in the future?

· Does the annuity let me get money when I need it?

· How much retirement income will I need in addition to what I will get elsewhere?

· After I buy the annuity, how much money do I need to have available to cover major expenses and emergencies? How much would I have for these expected expenses?


· Will I need income payments only for myself or for myself and someone else?

· How soon will I need income payments? How much retirement income will I need in addition to what I’ll get elsewhere?

· If the annuity only earns the minimum guaranteed interest rate, will that be enough income to meet my needs?

· Am I comfortable with the length of time that I’ll pay surrender charges if I withdraw money from the annuity?

· Am I interested in a variable annuity with the potential for higher earnings that are not guaranteed and willing to risk losing the principal?

· Is a guaranteed interest rate more important to me, with little or no risk of losing the principal?

· Or, am I somewhere in between these two extremes and willing to take some risks?



In addition, it is recommended that the client ask the insurance agent – and the insurance agent be prepared to answer – the following questions:

· Is this a single premium or flexible premium contract?

· What is the guaranteed minimum interest rate?

· What is the initial interest rate and how long is it guaranteed?

· Does the initial rate include a bonus rate and how much is the bonus?

· If there’s a bonus, when is it credited and on what amount?

· Do I lose any bonus if I take a lump sum rather than annuitize my accumulation value? Are there other ways I could lose the bonus?

· What renewal rate is the company crediting on annuity contracts sold last year?



· What charges, if any, are deducted from my premium?

· What charges, if any, are deducted from my contract value?

· How long is the term?

· What is the participation rate?

· For how long is the participation rate guaranteed?

· Is there a minimum participation rate?

· Does my contract have a cap?

· Is averaging used? How does it work?

· Is interest compounded during a term?

· Is there a margin, spread, or administrative fee? Is that in addition to or instead of a participation rate?

· Which indexing method, if applicable, is used in my contract?



· When is the earliest I can get money out of the annuity and how much can I get?

· What are the surrender charges or penalties if I want to end my contract early and take out all of my money?

· Can I get a partial withdrawal without paying charges or losing interest?

· If I take a lump sum and surrender the annuity, will the accumulated value or the way interest is credited change before I do this?

· Does my contract have vesting?

· Does my annuity waive withdrawal charges if I am confined to a nursing home or diagnosed with a terminal illness?

· What annuity income payment options do I have?

· What happens to the money in my annuity if I die?

· What is the death benefit?



The Need for Full Contract Disclosure and Complete Recordkeeping

As described in Section 10168.7 of the California Insurance Code, any contract which does not provide cash surrender benefits or does not provide death benefits at least equal to the minimum nonforfeiture amount prior to the commencement of any annuity payments shall include a statement in a prominent place in the contract that such benefits are not provided.

To protect the client, and himself, the agent should retain complete records to document that all regulations have been followed, required disclosures provided, and appropriate suitability determinations taken.


Required Disclosures

Agents in California must be aware of Life Agent Disclosure Requirements for Sales to Elders, identified as Attachment II as related to Sections 789.8 and 10234.8 of the California Insurance Code.

To review these disclosures, click here.


https://clients.pinpointglobal.com/NUCO/upload/attachmentII.pdf

Policy Cancellation and Refunds

Section 10127.10 of the California Insurance Code was amended as of July 1, 2004 with new regulations concerning policy cancellations and refunds.

These rules state that all certificates issued or delivered to individuals age 60 or older in California after January 1, 2004 must provide an examination period of at least 30 days after the receipt of the policy or certificate for purposes of review of the contract, during which time the applicant may return the policy to the insurer by mail or otherwise, voiding the certificate from the beginning, leaving the parties as if no contract had been issued. This 30 day period is known as a “Free Look Period.”

All premiums or policy fees already paid must be fully reimbursed by the insurer within 30 days of policy cancellation. Insurers are liable for interest in addition to premiums if refunds are not made on a timely basis.


Policies in effect before January 1, 2004 are considered to be in compliance with this regulation, and any provisions that conflict with this section are considered to be of no force or effect.

Most variable annuity contracts will not allow the investment of annuity funds into variable accounts until after the 30-day free look period has expired.

However, if the owner directed that the premium be invested in the mutual funds immediately, the owner would receive the actual account value in case of cancellation.

Policy Cancellation and Refunds


Lesson 10The Senior Market


Risks and the Senior Market

The topic of marketing financial products to seniors is coming under close scrutiny. There are several trends that financial regulators highlight as reasons for concern:

· There is concern regarding the inability of those approaching retirement to provide for a safe and comfortable retirement due to a lack of sufficient investments and savings.

· There is an abundance of financial planners and self-proclaimed experts in the field of financial planning for seniors. The true qualifications of these advisors is attracting the attention of state and federal regulators.

· There has been tremendous growth in the number of financial, insurance, and investment products targeted to seniors. Some of these products have investment features, risks, and fee structures that may not be appropriate for older purchasers.

Lesson 10: The Senior Market

· Borrowing products, including reverse mortgages, have been targeted to seniors as a means of increasing cash flow during the retirement years. While these products may be legitimate financial tools and suitable in some situations, consumers need to be aware of the characteristics of such products prior to entering into agreements.

· There has been a trend of marketing to senior citizens through seminars that often include a free meal as an enticement. These seminars often use oversimplified presentations to position investment and insurance products, including equity-indexed annuities, as easier to understand than they actually are. These products require a greater level of detail and attention before an informed decision can be made.

Risks and the Senior Market


Pre-Retirement vs. Post-Retirement Planning

There is a significant difference in planning during the pre-retirement and post-retirement years. In pre-retirement planning, consumers have longer time frames in which to endure the cyclical ups and downs of investment products.

During this phase, consumers are often willing to take more risk in exchange for the potential for greater rewards. With annuities, the pre-retirement period will match up to the accumulation phase.

During the post-retirement term, consumers become much more concerned with the possibility of outliving their resources. They want to protect their assets and investments, and their annuities are in the annuitization or payout phase.

Sound planning is especially important for the post-retirement years and, in addition, to income also must focus on health, long-term care, and estate planning.


Financial Concerns

An older client base will probably consist of three groups. The largest group will consist of people in their 50s and 60s who are contemplating retirement.

The next largest group will be those who have already retired, and there may be a small group of those who have retired and want to return to the workforce.

Sound retirement plans must take a long-range perspective. According to recent figures, the average of all 65-year-old Americans has a life expectancy of 18.7 years and the average 65-year-old white female has a life expectancy of 20.0 years.


On a personal level, the retiree must find interesting and satisfying activities during retirement, including activities that can be pursued if the retiree’s health deteriorates.

On the financial planning level, there must be an adequate level of income that will not be outlived.

Furthermore, since the retirement plan can be expected to continue for decades, the planner might want to adjust the portfolio to maintain or add at least some growth investments, instead of having a pure income orientation.

Financial Concerns


The planning challenge is to make sure that adequate income is available, and is not outlived.

However, there may be circumstances in which less income is better than more income.

Sometimes additional income places its recipient in a higher tax bracket, so adding more income does not necessarily result in a corresponding amount of after-tax income.

Income that is not needed may accumulate, making the potentially taxable estate larger.

Also, additional income is a negative rather than a positive for a person who receives Medicaid or is going to make a Medicaid application.

Financial Concerns


Sources of Post-Retirement Income

After retirement, a senior typically derives income from several sources. These sources might include:

· Qualified and nonqualified plan benefits provided by the employer

· Individual Retirement Accounts

· Social Security benefits

· Employment income, which may be earned from either post-retirement employment or by a spouse who has not yet retired

· Investment income, including annuity income and income from mutual funds, stock dividends, bond interest, and rental income from investment real estate

· Income from trusts set up by the retiree or by others for the retiree’s behalf


In some instances, the retiree will also inherit funds or become the beneficiary of life insurance on the life of a spouse or relative.

Some of these income sources are regular, others intermittent. Some of the sources are predictable, while others will fluctuate. Some continue for life, and others for only a period of years. Income may become available at various times in the post-retirement period.

For instance, a deferred annuity may begin payments several years after Social Security benefits and qualified plan distributions become available.

As part of this timing, consumers must be aware of the potential for surrender charges and potential tax penalties.

Sources of Post-Retirement Income


Insurance Concerns

Along with financial concerns, seniors must address insurance concerns.

Retiree Health Benefits

During the last several decades, employers have been hard-pressed by rising health costs. Therefore, it is less likely than before that a company will offer new retirees health benefits, and it is more likely that the employer will cut back or terminate benefits.

It is possible for employers to alter their retiree health benefit programs because retiree health benefits are considered to be welfare benefits. Although pension benefits under qualified plans are required to vest according to the schedules under the Internal Revenue Code, welfare benefits do not have a vesting requirement. If the employer has taken the precautionary step of drafting the retiree health benefit plan in a manner that reserves the right to alter the plan, the employer will probably be allowed to change the plan at its discretion.


In arranging health coverage for seniors, it is important to remember that Medicare coverage is determined on the basis of age or disability, not employment status. And while Social Security provides spousal benefits, Medicare does not.

A spouse who is under the age of 65 is not entitled to Medicare coverage merely because Medicare covers the other spouse, even though the spouse may have been covered as a dependent under an employment-related health plan. Therefore, a person who retires early and who does not have retiree health benefits must find some other way of filling the “gap” between employer-provided health coverage during his work life, and Medicare benefits.

Insurance Concerns


Long-Term Care Insurance

A person with long-term care insurance coverage who needs nursing home or home care can enter a facility or sign up with a local home care agency without worrying about whether the facility or agency participates in Medicaid or has openings for Medicaid patients.

Insured persons can plan their own financial lives, dispose of their assets, and make their own estate plans as they choose, with no need to fit into Medicaid’s requirements.

Many people find this freedom and flexibility extremely worthwhile.

Insurance Concerns


While the peace of mind can be priceless, long-term care insurance can also be expensive. Seniors should shop carefully and select the right policy. The right policy is one provided by an insurance company that is financially sound and that has a reputation for good service. The company should also plan to be in the long-term care insurance market for the long haul.

Seniors must determine a basic financial objective, such as the payment of the first dollar of expenses or of catastrophic expenses only, and select the desired benefits. The list of benefits available includes nursing home and home care as well as new innovative benefits such as adult day care, caregiver training, and assisted living facility housing.

Insurance Concerns


Certain long-term care policies are designed to meet certain tax requirements. These policies are called “qualified” long-term care policies.

Purchasers may be entitled to a tax deduction for part of the premium and generally get favorable income tax treatment when they collect benefits.

While qualified policies are popular, it is perfectly acceptable to sell non-qualified policies, and in fact, sometimes a non-qualified policy is the best choice for an individual purchaser.

Insurance Concerns


Estate Planning

Although there are certain basic estate planning concepts that are applicable to everyone, there are special issues that should be taken into account when a senior makes an initial estate plan or modifies an existing plan. Paradoxically, it can be hard to find the right moment to discuss estate planning with clients. To young, active clients, the entire subject seems impossibly remote (although it is often possible to get clients to understand the importance of maintaining adequate life insurance to protect growing families). To older clients, on the contrary, the subject may seem all too relevant and thus too threatening, with planning put off to “some other time.”

Insurance Concerns


Unfortunately, however, “some other time” might never arrive. Even if the older person is still alive, the person must have the mental capacity to make a will, set up a trust, or modify existing legal instruments and beneficiary designations.

Some of these tasks can be performed by an attorney-in-fact, who is a person authorized by a power of attorney, or a guardian.

However, in most states making a will is considered inherently personal, so guardians are limited in their estate planning powers.

It may be impossible to create a necessary document, or to update a document that is no longer relevant under current statutes.

Insurance Concerns


The older client’s estate plan has to strike a delicate balance. There must be funds for current and continuing needs, especially medical and care needs.

However, if a Medicaid plan is underway, it will be necessary to divest assets that are “excess” in the Medicaid context.

This can also work well with the estate plan, where the objective is to reduce the estate, preferably below the taxable level.

But in most instances, receiving Medicaid benefits will subject the estate to claims by the Medicaid agency after the recipient of benefits dies, so a decision will have to made whether receiving Medicaid benefits is more worthwhile than transmitting assets to future generations.

Insurance Concerns


An estate plan is a way to transmit wealth to other people, and across generations, in accordance with the client’s wishes, while reducing the amount of taxes that must be paid both during life and on the estate itself. The typical estate plan uses a will to govern transmission of assets at the will creator’s death.

Many estate plans use trusts, both for tax reasons and for convenient long-term management of assets.

Life insurance makes it possible to create an “instant estate” for a person who has family responsibilities but few financial assets. Even affluent people benefit by the use of life insurance, because it receives favorable tax consideration.

Combining devices often enhances the power of each separate planning device.

Insurance Concerns


Selling to the Senior Market

There can be a maximum age at which an annuity is no longer an available option.

However, since insurance companies set their own limits, even individuals as old as 75 years of age may qualify for an annuity, particularly if a lump sum is available to fund the contract.

The key annuity feature – a monthly payment for the annuity holder’s lifetime – can help supplement fixed income from other sources, such as social security, and eliminate the possibility of an individual outliving his or her source of income. No other financial product offers this feature.


The trade-off, of course, is that the funds used to secure the annuity are no longer available to pass on to the individual’s heirs or for emergency use, such as medical care or nursing home expenses (unless the annuitization phase has not yet begun, in which case a full or partial surrender may provide relief in such circumstances).

If an individual’s key concern is emergency access to funds or wealth protection, a low-risk, high-liquidity savings vehicle such as short-term bonds or CDs or even a savings account or may be a better option.

If the individual’s goal is to provide an inheritance, life insurance could be the right approach.



It is an important responsibility of the advisor to follow the letter and the intent of regulations concerning the marketing and sale of annuity products to seniors. Although many seniors are fully able to grasp the nuances of an annuity purchase, many are not. It is up to the advisor to properly and fairly represent the advantages and disadvantages of an annuity sale when working with a senior client.

As with other investment options, the purchase of an annuity means that the funds used to buy the contract will not be available for other uses. When working with seniors it is extremely important to ensure that insurance needs for health, long-term care and life insurance have been carefully reviewed and that the client is satisfied that coverage is appropriate before making an annuity buying decision.



With the contract features associated with the various types of annuities, agents must be concerned that the senior client understands the product that is being offered. Annuities can be very complex products.

Even those who have all of their mental faculties can struggle with product complexity.

Imagine the challenge when working with a client who may lack the short-term memory or judgment to knowingly purchase an insurance product.

Agents must be informed of the indicators of impaired judgment.



Recognizing Impaired Judgment – Financial advisors must be alert to symptoms of dementia and other physiological disorders that can afflict seniors’ ability to make competent decisions. Symptoms include:

· Progressive forgetfulness, short term memory loss

· Difficulty following directions

· Difficulty making decisions

· Language impairment (using the wrong word)

· Repetition of actions and statements

· Changes in personality and mood (withdrawal, anxiety, loss of initiative)

· Disorientation to time and place

· Difficulty concentrating

· Poor judgment (wearing inappropriate clothing)



Advisors who observe one or more of the above symptoms should be particularly alert to the decision-making ability of the client.

If a senior client does not seem to understand what he or she is buying, particularly details such as surrender periods, the differences between different products and other important criteria, it is not ethical to continue recommending a sale.



Recissions Based on Mental Incompetence

California Civil Code Sections 38 and 39 address rescission rights for contracts entered into by persons with unsound mind. The code states that a person entirely without understanding has no power to make a contract of any kind, but the person is liable for the reasonable value of things furnished to the person necessary for the support of the person or the person's family.

A conveyance or other contract of a person of unsound mind,but not entirely without understanding, made before the incapacity of the person has been judicially determined, is subject to rescission. A rebuttable presumption affecting the burden of proof that a person is of unsound mind shall exist for purposes of this section if the person is substantially unable to manage his or her own financial resources or resist fraud or undue influence. Substantial inability may not be proved solely by isolated incidents of negligence or improvidence.


Unique Ethics and Compliance Issues

The increasing attention to suitability for seniors has resulted from the vulnerability of this market. There are fears that seniors may fall prey to scams and unscrupulous producers. Because of this, it’s likely that senior products will continue to come under close scrutiny by insurance and securities regulators.

There are several reasons seniors, especially those with diminished capacity, are targeted for fraud:

· Older Americans are most likely to have a nest egg and unscrupulous producers will focus efforts on the market segment because they are most likely to be in a financial position to purchase their products.

· The “senior” generation was raised to be polite and trusting. While these are positive and admirable characteristics, they are also traits that fraud perpetrators like to take advantage of.


· Senior citizens are far less likely to report fraud because they are ashamed it occurred, don’t realize they’ve been scammed, or don’t know where or how to report it. They may also decide against reporting it out of fear that family members will determine they are incompetent and have them institutionalized or attempt to be appointed guardians of their financial affairs.

· Even when fraud is reported, the elderly are often poor witnesses and unable to provide the detailed information that investigators need to solve the cases.

· By preying on fears such as outliving one’s resources, seniors may be willing to believe exaggerated claims in hopes these products will relieve them of their worries.



Although the insurance and annuity industry is heavily regulated and there are many codes and regulations that must be followed, it is equally important to adhere to strict standards of ethics, market conduct, and compliance. Trust plays a key role in consumers feeling confident and comfortable with their insurance agent or financial advisor.

Compliance refers to following the law. To ensure that insurance professionals do so and accurately represent the insurance products and the performance features recommended to consumers, the insurance profession is one of the most heavily regulated industries in the country. The insurance industry is primarily regulated by each individual state, which explains the need to be licensed by each state in which the agent plans to do business. State insurance laws cover a wide range of activities including unfair trade practices and unfair claims settlement practices.



Ethics means doing what is right. You can be in compliance with the law without doing what is right. Because you will be providing a service which involves people putting their trust and faith in you, you have an even higher responsibility to do what is right. While there are many ways to be “ethical,” perhaps the most widely accepted way is to “do unto others as you would have them do unto you.”

Over the past several years, there have been numerous scandals involving some of the largest and most highly regarded corporations in America. Most of those who helped perpetrate those scandals were vested with considerable trust by employees and stockholders alike. Many of these same individuals have proclaimed their innocence on grounds ranging from their lack of awareness of what was going on to their belief that their boards of directors had either implicitly or explicitly authorized their actions. Most observers view their behavior as, if not criminal, certainly morally corrupt.



Many professionals are placed in a position of trust—including doctors, lawyers, architects, and, of course, insurance producers. One definition of a professional is someone who has expertise that an ordinary person would not necessarily have on their own.

As a result, a professional is relied on for that expertise and he must act responsibly due to the position of trust in which he is placed. In essence, the professional must act in a moral and ethical manner. While there is considerable debate about what morally ethical behavior is, few would argue that, as it applies to an insurance producer, it means putting your client’s needs first, being honest, and being fair.



It is certainly not enough to comply with laws and regulations alone, because one can be in compliance with the “letter” but not the “spirit” of the law.

For example, you may be required, by law, to have a prospect for life insurance sign a disclosure form indicating that she understands the risks inherent to a particular product.

While her signature on the document may be compliant with the “letter” of the law, it may not be compliant with the “spirit” if that individual did not understand what she was signing (and you were aware of that).



Most insurance industry codes of ethics expect conformance with the following principles:

· Place the client’s needs first: the insurance licensee should never act in a manner, or recommend or sell a product, that is motivated by self-interest. The client’s needs always come first.

· Be fair, objective, and impartial: any client insurance problem or deficiency that you uncover has many possible solutions. Insurance programming is just as much “art” as “science”—at the very least because no one can predict the future with any certainty (and therefore, it is impossible to know in advance if an insurance strategy is correct or not). Always present your client with alternative solutions and help them decide on a course of action with which they are comfortable.



· Act diligently: you have a responsibility to act in a reasonably prompt manner, whether that involves providing a client with recommendations or handling a request for policy service.

· Avoid conflicts of interest: do not engage in actions with, or make recommendations to, a client in any circumstance in which your ability to be fair, objective, and/or impartial is compromised.

· Act within one’s own area of competence: do not advise and/or sell products to your clients in situations in which expertise is required that you do not possess. For example, you may encounter a complicated business situation requiring an insurance funded buy-sell agreement. How such a plan is structured can have serious tax and financial consequences. Unless you have specific expertise in this area, bring in an expert.

· Continually upgrade your skills: the field of insurance is constantly changing. Products are changing, tax laws and insurance regulations are changing, and the needs and circumstances of clients change as well. You have a responsibility to continually upgrade your skills so you can provide the best possible service and advice to your clients. The necessity of this is underscored by the fact that every state requires that you satisfy state-approved continuing education requirements on an ongoing basis.



Suitability for the Senior Market

Suitability, or the appropriateness of an annuity for a particular client, continues to be a hot topic.

This is especially important when marketing to the elder population.

The insurance agent must make every effort to gather the necessary information to determine the products that are suitable for a client’s current and future circumstances – as explained throughout this course.

Once they have established the products that are appropriate, they will be guided by experience and training in making their final recommendation.


Suitability for the Senior Market

As part of this, consider FINRA’s suitability and Know-Your-Customer guidelines, which highlight three suitability obligations:

1. Reasonable Basis – firms must have a reasonable basis to believe, based on adequate due diligence, that a recommendation is suitable at least for some investors;

2. Customer Specific – firms must have reasonable grounds to believe a recommendation is suitable for the specific investor; and

3. Quantitative – firms must have a reasonable basis to believe the number of recommended transactions within a certain period is not excessive (i.e., that the investor’s account is not being churned).


Lesson 11Role of California Insurance

Guarantee Association


Role of California Insurance Guarantee Association

•Insurance companies licensed in California to sell life and health insurance and annuities must be members of the California Life and Health Insurance Guarantee Association (“CLHIGA”), an association created to provide some protection for consumers in the unlikely event that a member insurer becomes financially unable to meet its obligations. If this should happen, the Guarantee Association would assess its other member insurance companies for the money to pay the claims of insured persons who live in this state and, in some cases, to keep coverage in force. However, the protection is limited, and companies must be careful not to form an impression in the minds of potential customers that it is.

Basically, California residents who own eligible life or health insurance policies or annuity contracts are protected by the California Life and Health Insurance Guarantee Association. This protection is also for insurance issued under a group insurance contract. The beneficiaries, payees or assignees of insured persons are protected as well, even if they live in another state.

Lesson 11: Role of CLHIGA


However, such persons are not protected if:

· Their insurer was not authorized to do business in California when it issued the policy or contract.

· The policy was issued by a health care service plan (HMO), Blue Cross, Blue Shield, a charitable organization, a fraternal benefit society, a mandatory state pooling plan, a mutual assessment company, an insurance exchange, or a grants and annuities society.

· They are eligible for protection under the laws of another state (such as the insolvent insurer was incorporated in another state whose guaranty association protects insureds who live outside that state).



The Guarantee Association also does not provide coverage for:

· Unallocated annuity contracts (those not issued to and owned by an individual).

· Self-funded or uninsured employer and association plans.

· Synthetic guaranteed interest contracts.

· Any policy or portion of a policy which is not guaranteed by the insurer or for which the individual has assumed the risk, such as a variable contract sold by prospectus.

· Any policy of reinsurance unless an assumption certificate was issued.

· Interest rate yields that exceed an average rate.

· Any portion of a contract that provides dividends or experience rating credits.



Even when a policy or contract is eligible for coverage, benefits are limited to 80% of what the life insurance company would owe up to $100,000 in cash surrender or present value or $250,000 in death benefits.

Also, benefits are capped at $250,000 no matter how many policies or contracts are owned.

Insurers are required to provide a Notice of Non-Coverage when offering policies or contracts for sale that are not covered by the fund.



While the California Guarantee Fund is designed to provide relief for annuity and insurance policy holders of firms that go out of business, there is no guarantee that such individuals will receive full value of their claim.

Several ratings agencies are available to help evaluate a particular company’s financial strength.

These services are often used by agents, financial planners, and consumers.

Well known rating services include those from the A.M. Best Company, Moody’s, Standard & Poor’s, and Fitch.

Ratings take into account a company’s investment strategy, marketing philosophy, profitability, and history.


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California Annuities Training Program

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