Annuities

1. Annuities • 1. Reverse application of the law of large numbers as it is used in life insurance. • 2. Law of averages permits a lifetime guaranteed income to each annuitant. • 3. Persons who live longer than average offset those who live a shorter-than-average period. • 4. Every payment to annuitant is part interest, part principal, and part survivorship benefit.

2. Annuities • Classification of annuities • 1. Individual versus Group • 2. Fixed versus Variable • 3. Immediate versus Deferred • 4. Single Premium versus Installment • 5. Single Life versus Two or More Lives • 6. Pure Life Annuity versus Annuity Certain

3. Annuity Certain Contracts • 1. Pure life annuity • 2. Life annuity with period certain • 3. Life annuity with installment refund • 4. Life annuity with cash refund

4. Tax Treatment of Annuities • Investment Nontaxable Payment X in Contract = Return of Expected Return Capital • $6,000 = $60,000 = $60,000 ($500 X 12) X 15 $90,000 • $6,000 X $60,000 = $4,000 $90,000

5. Specialized Annuities • Single-Premium Deferred Annuity • 1. Increased popularity since TRA-86 eliminated many tax shelters. • 2. Currently taxed same as other annuities:earnings accumulate on tax-deferred basis. • 3. Some insurers sell SPDAs with deposit premium as low as $2,500, but more common minimum is $10,000.

6. Specialized Annuities • Market-Value Adjusted Annuities • 1. Cross between variable and fixed dollar annuities • 2. Interest rate is fixed for a specified period, but cash surrender value fluctuates with value of underlying securities if policy is surrendered before end of period • 3. At set intervals (e.g., 5 or 10 years) withdrawals permitted without market value adjustment

7. Specialized Annuities • Two-Tier Annuity • 1. A dual value, dual interest annuity • accumulation value, equal to premiums paid plus interest • surrender value, which is subject to a permanent increasing surrender charge, designed to discourage lump-sum withdrawals • 2. Accumulation value is available only under an annuity pay-out

8. Specialized Annuities • Reversionary or Survivorship Annuity • 1. Life insurance on one person (nominator). • 2. Policy proceeds paid as a lifetime annuity to the beneficiary (annuitant). • 3. If beneficiary dies before the nominator, the policy expires without value. • 4. Usually written with a young person as the nominator and an older person (e.g., parent) as the annuitant.

9. Equity-Indexed Annuities • First appeared in 1996 and quickly captured a significant portion of the annuities market. • A fixed annuity that earns interest or provides benefits linked to performance of an equity index, such as the S&P 500. • Generally, the crediting rate is a function of • the relative change in the index, • the participation rate (i.e., percentage of index growth passed on to policyholders), • any caps imposed on the crediting rate. • Also usually have minimum interest guarantees and comply with the minimum nonforfeiture law.

10. Variable Annuity • 1. Designed as means of coping with inflation. • 2. Premiums invested in common stocks or similar investments. • 3. Based on assumption that the value of a diversified portfolio of common stocks will change in the same direction as price level. • 4. Variable annuity may be variable during accumulation period and fixed during payout period of variable during both accumulation and payout period.

11. History of Variable Annuity • 1. Originated in 1952 by CREF, which was created by the TIAA for college faculty. • 2. First variable annuities for the public were issued in 1954 by PALIC of Little Rock, Arkansas, (intrastate only) followed by VALIC (interstate). • 3. Litigation over regulation by the SEC or state insurance departments was settled by U.S. Supreme Court: currently regulated by both SEC and the states.

12. CREF Performance • Unit Year Value • 1952 $1.02 • 1955 1.95 • 1960 3.39 • 1965 5.40 • 1970 6.17 • 1975 6.48 • 1980 11.71 • 1985 24.42 • 1990 44.41 • 1995 80.81 • 1998 151.74

13. Annuities as Investments for Retirement • 1. Return earned over life of an annuity depends on several features. • 2. Most important determinants of the rate of return are: • interest rate • surrender charge • administrative expenses

14. Annuities - Interest • 1. “Current” rate of interest is guaranteed for a specified number of years, after which it may be changed, subject to a specified minimum. • 2. Guarantee period may range from 1 year to up to 10. • 3. Usually, the longer the guarantee period, the lower the guaranteed rate.

15. Annuities - Surrender Charges • 1. Although some insurers still use a front-end sales fee (4% or 5% of premium), most insurers use a surrender fee for early withdrawals. • 2. Surrender fee usually begins at from 8% to 10% and declines to zero after from 7 to 15 years.

16. Annuities - Administrative Expenses • In addition to the surrender charges, most insurers charge an administrative fee. • annual maintenance fee usually from $25 to $50. • for variable annuities, asset management feels ranging from 0.25% to 2% of accumulated assets are charged.

17. Qualified Retirement Plans • Qualified plans are those that conform to the requirements of federal tax laws and for which the law provides favorable tax treatment. • 1. Employee contributions are tax deductible when they are made. • 2. Employee is not taxed on employer’s contribution or investment earnings until benefits are distributed.

18. ERISA • Employee Retirement Income Security Act of 1974 (ERISA) establishes federal standards for qualified retirement plans: • 1. Prescribes which employees must be included. • 2. Establishes minimum vesting standards. • 3. Sets minimum funding standards. • 4. Requires extensive reporting and disclosure information about pensions and other employee welfare programs.

19. Qualification Requirements • 1. Designed for exclusive benefit of employees. • 2. In writing and communicated to employees. • 3. Must meet one of several vesting schedules. • 4. Cannot discriminate in favor of officers, stock-holders or highly compensated employees. • 5. Must provide for definite contributions by employer or definite benefits at retirement. • 6. Life insurance included only on an incidental basis. • 7. Top-heavy plans are subject to special vesting and contribution requirements.

20. Vesting Requirements • 1. No vesting for 5 years, 100% vested after 5 years. • 2. 20% vested after 3 years with 20% per year thereafter so employee is 100% vested at the end of 7 years. • 3. For top-heavy plans: • 100% in three years, or • 20% per year after first year

21. Types of Qualified Plans • 1. Defined Benefit Pension Plans • 2. Defined Contribution Pension Plans • 3. Qualified Profit-sharing Plans • 4. Employee Stock Ownership Plans • 5. Section 401(k) Plans • 6. Simplified Employee Pensions • 7. Keogh Plans • 8. Section 403(b) Plans • 9. SIMPLE IRAs and SIMPLE 401(k) plans

22. Factors Influencing Benefit Levels • Benefit received by employees at retirement is based on a formula applicable to all employees. • 1. All plans fall into one of two benefit formula categories • defined contribution • defined benefit. • 2. Plans may be contributory (with employee contributions) or noncontributory (where employer bears the entire cost).

23. Employee Contributions • 1. When employees contribute to a profit-sharing plan, it is usually called a “thrift” or “savings” plan. • 2. Employee contributions are not usually deductible, but investment income on such contributions is exempt from taxes until distributed.

24. Amount of Benefits or Contributions • Defined Contribution Plans • 1. Work exactly as the name implies: employer’s contribution is set by the employment agreement • 2. Contribution is usually a percentage of compensation, such as 5% or 10% of employee wages

25. Amount of Benefits or Contribution • Defined Benefit Plans • 1. In defined benefit plan, amount of benefits employee will receive is specified in the benefit formula • 2. In most benefit formulas, retirement benefit is a function of employee’s salary, the benefit accrual rate, and employee’s years of service • 3. Most plans are final average salary plans but some are career average salary plans.

26. Amount of Benefits or Contributions • FINAL AVERAGE SALARY PLAN • Benefit depends on salary earned in final years of employment and number of years worked • example: 1% of average monthly salary during final three years of employment for each year employed • an employee with 35 years employment would receive 35% of average monthly employment in the final three years

27. Amount of Benefits or Contributions • CAREER AVERAGE SALARY PLAN • Benefit depends on salary earned in all years of employment and number of years worked • example: 1% of average monthly salary during all years of employment for each year employed, • an employee with 35 years employment would receive 35% of average monthly employment over employment career.

28. Amount of Benefits and Contributions • Defined Contribution Plans • 1. Maximum allowable contribution to a defined contribution plan varies with the type of plan • 2. For a defined contribution pension plan, the limit is 25% of year’s earnings, subject to a dollar maximum that is adjusted for inflation • 3. Dollar maximum was set at $30,000 in 1986 and will be adjusted for inflation when dollar maximum for defined benefit plans reaches $120,000

29. Amount of Benefits or Contributions • Defined Benefit Plans • 1. Maximum benefit in a defined benefit plan is 100% of employee’s earnings in three consecutive years of highest earnings. • 2. Dollar maximum for defined benefit was set at $90,000 in 1988 and is adjusted for inflation since that time.

30. Minimum Contribution or Benefit - Top-Heavy Plans • 1. For defined contribution plans, minimum contribution is 3% of employee compensation. • 2. For defined benefit plan, minimum is the contribution required to fund a benefit equal to 2% of average compensation in 5 highest years times years of service. • Minimum benefit need not exceed 20% of such average compensation.

31. Contribution for Keogh Plans • 1. Keogh plans are subject to essentially the same limitations, deductions and benefits as applicable to corporate pension and profit-sharing plans. • 2. A special definition of earned income is used to make contributions by self-employed persons correspond to those for a common-law employee. • 3. Percentage limitations apply after the contribution to the plan is deducted from income.

32. Keogh Plan Contribution Illustrated • Partnership establishes a defined contribution plan with 25% of employee compensation. • Partner earns $100,000. • Partner’s contribution is limited to 25% of income after the contribution: • Taxable NontaxableIncome Contribution Total • Employee $40,000 $10,000 $50,000 • Owner 80,000 20,000 100,000

33. Integrated Benefit Formulas • Integration: Adjusting for Social Security • 1. Internal Revenue Code provides that the employer may consider social security benefits in setting contribution rates • 2. Employer may contribute a higher percentage for wages in excess of the maximum FICA wage base than for wages below the base • 3. Compensates for the fact that social security provides a higher replacement rate for lower-paid workers than for highly-paid workers

34. Integration Formulas • 1. Excess Plan • Provides greater benefits on compensation that exceeds wages subject to FICA tax. • 2. Offset Plan • Provides benefits on employee’s full compensation, but reduces benefits by a percentage of social security benefit.

35. Maximum Contribution 401(k) Plans • 1. Permit pretax contributions (called “elective deferrals”) by employees. • 2. Employees elect to contribute to a profit-sharing plan and instruct employer to make contributions on their behalf. • 3. I.R.C. treats contributions as if they were made by employer rather than by employee. • 4. Limit on employee deferrals to 401(k) plan or SEP is the lesser of 25% of compensation or a dollar maximum (set at $7,000 in 1988 and indexed for inflation since that time).

36. Maximum Contribution - Simple Plans • Eligible employees may choose to have the employer make payments to the SIMPLE plan or to receive these payments directly in cash. • Employee must be permitted to elect salary reduction contributions, expressed as a percentage of compensation for the year. • Employer must match contributions of employees up to 3% or contribute a flat 2% of compensation for each employee regardless of whether the employee elects to participate. • The maximum annual pretax contribution an employee may make under a SIMPLE is $6,000, which will be indexed for inflation after 1997.

37. Nature of the Employer’s Promise • INVESTMENT RISK • Under defined contribution plan, employer promises to make contributions to an account that earns investment income. • Since benefits depend on contributions and investment income, the employee bears the investment risk in defined contribution plans. • Because the employee bears the investment risk, he or she is likely to have some say in how funds are invested.

38. Nature of the Employer’s Promise • INVESTMENT RISK • In a defined benefit plan, the employer promises to provide a certain level of retirement benefits to the employee. • Employer therefore bears the investment risk in a defined benefit plan.

39. Advantages to Younger and Older Employees • 1. A higher proportion of ultimate retirement benefits are earned in early years of participation in a defined contribution plan. • 2. Present value of benefits promised to younger workers under a defined benefit plan tends to be small compared with present value of benefits promised when the worker is closer to retirement.

40. Forfeitures • 1. Forfeitures in defined contribution plans may be used to reduce future employer contributions or they may be reallocated among participants. • 2. In a defined benefit plan, forfeitures may be used only to reduce future employer contributions.

41. Protection for Inflation • 1. Defined benefit final average salary plans provide greatest protection against inflation since retirement benefits are based on earnings immediately preceding retirement. • 2. Career average plans base benefits on employee’s salary throughout career. • 3. Some plans provide cost-of-living adjustments during retirement years, but this is not common.

42. Other Benefits • Pre-Retirement Death Benefit • 1. Optional, except for contributory plans, where employee’s contribution is payable as death benefit. • 2. Some employers pay death benefit based on employer’s contribution. • 3. Federal law requires payment of a qualified preretirement survivor annuity to surviving spouse of a vested participant. • 4. Some plans provide preretirement death benefit through life insurance.

43. Other Benefits • Postretirement Death Benefits • 1. Survivor benefits may be provided by annuities with joint and survivor options or period certain payments. • 2. Federal law requires spousal consent for a participant to elect out of the automatic 50% joint and survivor option.

44. Other Benefits • Disability Benefits • 1. Some plans treat disability as an early retirement. • 2. More favorable approach provides for continued contributions on behalf of a disabled employee.

45. Distribution Requirements • 1. Commencement of benefits: April 1 after year in which individual reaches age 70 1/2 or the date of retirement, if later. • 2. Distribution must be made over • the life of the participant or joint lives of participant and spouse (i.e., an annuity). • the life expectancy of the participant and his or her beneficiary.

46. Premature Distributions • 10% penalty prior to age 59 1/2 except for • deductible medical expenses • in form of lifetime annuity • at age 55 by worker who meets plan requirements for retirement

47. Taxation of Distributions • 1. Retirement benefits traditionally paid to participants in form of a lifetime annuity. • 2. Installment distributions taxable only to the extent they exceed employee’s investment in the contract. • 3. Lump-sum distributions may be rolled-over into an annuity and taxed under installment rules. • 4. Lump-sum distributions that are not rolled-over may be subject to five-year averaging.

48. Individual Retirement Accounts • 1. A person who is not covered by an employer-sponsored plan can make tax-deductible contribution to an IRA of $2,000 annually. • 2. Persons covered by an employer plan may be entitled to same deduction, a partial deduction, or no deduction, depending on income. • 3. Persons not eligible for deduction may make a nondeductible contribution. • 4. New rules under TRA-97 allow a full $2,000 deductible contribution by a spouse who is not employed outside the home.

49. Individual Retirement Accounts • Adjusted Gross Income Phase Out Levels • $25,000 to $35,000 for single taxpayers • $40,000 to $50,000 for married filing jointly • 0 to $10,000 for married filing jointly • TRA-97 gradually increases AGI phase-out levels to double the present level by 2007.

50. IRA Taxation Formula • Total Nondeductible Tax-Free Amount Contributions All _ Withdrawals Distributed X Years to IRAs in Prior Years From IRA Fair Market Value Amount DistributedDuring Year of all IRAs at + From IRA During End of Year the Year