Annuities: Module V-G

ANNUITIES: MODULE V-G

THE PRODUCT

Annuities have been called 'upside-down Life insurance,' a phrase that refers to the fact that annuities are designed to pay out while the purchaser lives, while Life insurance is designed to pay once the purchaser has died. An annuity is the systematic liquidation of an estate; Life insurance creates an estate.

The basic principle behind annuities is simple: The purchaser pays the insurance company a premium, either all at once or in installments, and in return for that premium expects the insurer to pay him or her a periodic income for Life, beginning at a specified period of time. The amount of the income received is determined by a number of factors, including total premiums paid, age when benefits begin, type of contract purchased, and sometimes health or sex.

Annuities are most commonly used for retirement purposes-to provide a tax-deferred buildup of assets that will result in a steady income to the annuitant. Annuities are generally not sold for short-term purposes. They are often involved in corporate pension and profit-sharing plans; these are group annuities. For the sake of clarity, this sales campaign will deal with the sale of annuities to individuals.

As with other forms of Life insurance and financial services, the annuity principle has been expanded upon over the years, with insurers coming out with innovative products to meet client needs. Today, there are a vast array of annuities from which to choose. Classifying them all is a difficult task, but there are some basic areas that can be explained. Every annuity will have features that fall into these five areas: method of paying premiums, date benefits begin, determination of benefit, method of benefit payout, and method of accumulating interest.

Annuities can be purchased with a single premium or through a series of scheduled or installment premiums. A single-premium annuity is purchased with a lump sum (often the proceeds of a Life insurance policy that is to be liquidated over the beneficiary's lifetime). Scheduled-premium annuities call for regular payments, with annual payments being common. Annuitants make annual payments for a specified period of time. The net premiums accumulate at interest until the payout begins. Other scheduled-premium annuities might specify a different timetable for payments. Still another form of payment is the flexible-premium annuity. The buyer decides when and how much premium to put into his or her annuity. Again, premiums accumulate at interest until the payout begins.

Annuity benefits either begin immediately, or are deferred. In an immediate annuity, benefits are payable immediately after the contract is purchased. An immediate annuity is purchased with a single premium and benefit payouts begin right away. With the exception of settlement options under Life insurance (where an annuity is purchased with Life insurance proceeds to provide a lifetime income for a beneficiary), few immediate annuities are purchased on an individual basis. More such annuities are purchased on a group basis, in connection with pension plans.

Under a deferred annuity, benefit payments begin at the end of a given number of years or at optional ages established in the annuity contract. Deferred annuities may be purchased with either a single premium or a series of premiums. Deferred annuities have two periods: the deferred period and the liquidation or payout period. Minimum guarantees can be made available in one of these periods, in both, or in neither. For example, if the insured dies during the deferred period, before any payments have been made, the insurance company can guarantee that a certain benefit will be paid. The insurer can also guarantee that a certain amount of money will be paid during the liquidation period, even if the insured dies early on.

Insurers have devised a number of ways in which annuitants can receive the benefits of their annuity, Here are the most common forms:

Straight Life-also known as life annuity-no refund. This is the simplest arrangement. The annuitant is paid an income throughout his or her lifetime. Upon the annuitant's death, payments cease-there is no further equity in the contract, regardless of how few benefit payments have been made. This is the purest form of annuity and offers the largest income payment per dollar of purchase price. A straight life annuity contract is used often in group annuities, but not very often in individual annuities. Few annuitants want to risk the loss of their principal to the insurer in the event of early death.

Life with Period Certain-Under this contract, the annuitant receives a guaranteed income for life, but is also guaranteed a minimum number of payments, such as 120 (10 years) or 240 (20 years). If the annuitant dies before the minimum number of guaranteed payments has been made, the payments are continued to his or her beneficiary for the remainder of the stipulated period. If the annuitant survives the guaranteed payment period, the benefits continue until his or her death. The period certain benefit will cost the annuitant a portion of the living benefit because it's guaranteed; how much depends on the age when benefits commence.

Refund Annuities-This annuity also guarantees an income for life, but in addition guarantees a refund of the purchase price of the annuity after the annuitant's death. An installment refund annuity promises to continue the periodic payments after the death of the annuitant. A cash refund annuity promises, upon the death of the annuitant, to return in cash the difference between benefits drawn and the purchase price paid by the annuitant. If the annuitant lives long enough to collect the purchase price in income payments, then at his or her death, all benefits and values terminate.

Joint-and-Last-Survivorship-Under this contract, the income is payable throughout the joint lifetimes of two or more annuitants and continues through the life of the last survivor. Sometimes the contract will provide for a reduction in income payments upon the death of the first annuitant. Commonly, joint-and-last-survivorship annuities are written on two lives, usually husband and wife, to guarantee income to both as long as either may live. This type of annuity may also have a period certain written into the contract, meaning that, if both annuitants die before the period is over, benefits will continue to be paid to a beneficiary for the remainder of the period.

Annuity Certain-This is a contract that provides payments of given income for a specified number of years, independent of the annuitant's life or death. Upon the termination of these years, the payments cease. Life expectancy is in no way a factor in the payments. This form of annuity is commonly used as a method of paying out Life insurance proceeds to a beneficiary.

Method of Accumulating Funds

The premiums paid into an annuity contract will accumulate interest in one of two ways: at a fixed rate guaranteed by the insurer, or at a variable interest rate determined by the performance of funds in which the premiums are invested. The first type of contract is known as a fixed annuity, the second as a variable annuity. Fixed annuity contracts are the simplest. Premiums accumulate at rates of interest set by the company, and the amount of each annuity payment is determined by when payments begin.

A variable annuity contract is more complicated in that premiums are invested in a segregated portfolio of equity securities. Both the cash values and the retirement income of the annuity reflect the performance of the invested funds, rising or falling as the market values of the funds' securities increase or decrease.

Another type of annuity contract combines the fixed and variable annuity concepts by guaranteeing a fixed rate of interest on part of the premium and investing the rest at a variable rate of interest.

No matter what the type of annuity, under current tax law, earnings accumulate on a tax-deferred basis. The annuitant is not taxed on any earnings in the account until the payouts begin. Taxation on the annuity payments is based on a formula. Because tax laws change, it's wise to keep advised by your CPA on the latest developments, so you know what to communicate to your clients and prospects.

Considerable diversity exists in the types and amounts of charges (in addition to premium) in an annuity contract. Some charges are fixed at policy issue, others may be charged from time to time after the premiums are being paid. A typical contract might contain some or all of the charges outlined below. Note that each insurer might refer to these charges by a different name.

Percent of Premium-This is a load deducted from each premium paid. The percentage may be reduced after the contract has been in force for a certain number of years or after total premiums paid have reached a specific level.

Contract Fee-A flat dollar amount charged at issue or upon renewal dates.

Transaction Fee-Charge per premium payment or other transaction.

Surrender Charge-A fee charged for surrendering (giving up) the contract before income payments have started. The charge is usually a percentage of the contract value or of premiums paid. The charge may be reduced or even eliminated after the contract has run for a number of years. In some contracts, the surrender charge will take the form of a reduction in the interest rate credited to the account. The charge may be eliminated altogether if the interest rate declared by the company falls below a floor rate assumption.

Other important features and terms often found in an annuity contract include:

Value-Premiums paid, minus charges, plus interest rate.

Interest-The interest earned on the premium payments or principal cannot fall below the guaranteed interest rate stated in the contract. However, the interest usually credited to the account is the company's current interest rate, which is generally higher than the guaranteed rate. Current interest rates will increase or decrease at the company's discretion; companies differ in their viewpoints and philosophies in determining the current interest rate.

Death Benefit-If you die before annuity payments begin, a death benefit clause in the contract provides that the contract value will be paid to your beneficiary. If total premiums paid are larger than the contract value, contracts generally will pay the larger amount.

Surrender Benefit-Most annuity contracts will allow you to surrender your contract if income payments have not yet started. Upon surrender the contract terminates, but you may receive a surrender benefit. The benefit is usually the difference between the contract value and any surrender charges assessed.

Waiver of Premium-For an additional charge, some companies will pay the annuity premiums for you if you become disabled and lose your income.

PROS

Leading the list of advantages of annuities are guaranteed income for life and tax-deferred buildup of income.

For the person who wants to ensure an income and a build-up of earnings for retirement, annuities are often an ideal vehicle. The policy contract guarantees a certain income (subject to the types of annuity payout options discussed previously). The annuitant is guaranteed not to outlive the income. This eliminates the uncertainty of facing an old age, unable to work, with no source of support.

For someone looking to provide for retirement with a minimum of taxation, annuities provide advantages. The Tax Reform Act of 1986 imposed restrictions on many other forms of tax sheltering, notably limited partnerships. Many affluent taxpayers are looking for other ways to defer taxes. In addition, the Act tightened the alternative minimum tax rules to make it more difficult to avoid tax through the use of tax preference items. This makes annuities particularly attractive to wealthy individuals with high alternative minimum taxable income.

Variable annuities may look especially attractive to some prospects because of the Tax Reform Act's elimination of favorable tax treatment for capital gains. In the past, a drawback of variable annuities was that they transformed capital gains into ordinary income. With all income now taxed at the same rates, this disadvantage is removed. Also, mutual fund investors, particularly those with a long-term perspective, can consider variable annuities as a tax-favored alternative.

The major disadvantage to annuities as seen by many is the fact that they are long-term investments. Although many annuity contracts make provisions for the withdrawal of a certain portion (usually 10%) of the contract value each year within the first seven or eight years, these withdrawals are treated differently by the IRS than are withdrawals (borrowing) from a Life insurance contract. With an annuity withdrawal, ordinary income tax must be paid on interest income when funds are withdrawn. Also, some insurers may charge a surrender charge, depending on the amount and timing of the withdrawal. So, annuities should not be looked upon as a way to build up tax-deferred 'ready' cash.

Another psychological disadvantage for some people is that they don't like to use up their capital to provide themselves with a retirement income. They want to preserve much of their estate to leave behind to heirs. Some are content to live on an income well below that to which their savings entitle them in order that they may conserve their estates. Of course, the solution is to start the annuity early enough so as to have time to build additional resources in the estate to leave to heirs, while still providing a secure retirement income.

Also, annuity contracts can incur short-run losses. Current investment rates may drop for a period of time. If the purchaser is looking for fast growth short term, traditional annuities are not the answer (but check out 'index annuities').

A good annuity insurance company will have a wide range of annuity products, and be A or A + rated by Best's. Some characteristics to look for in a good annuity company include:

1. Financial strength. Evaluate the carrier's stability and reliability. Look at its ratio of surplus to liability, its ratings, interest rates, charges, loads, and surrender fees.
2. Investment philosophy. This is especially important if you're going to be selling the carrier's variable annuity. Carefully study the company's investment guidelines. Consider risk in the light of available margins to meet contingencies. Outside expertise may be a plus, especially for companies in which size does not justify a well-staffed, highly professional investment department.
3. Range of products. Will your insureds have a variety of choices as to how their annuity contract will be structured? For example: date when payments begin, how long payments continue, premium options, optional benefits, and so on.
4. Software illustration capacity. Look for a company that can back you up with illustrations, marketing tools, and service.
5. Annuity Pocket Guides. Check each possible company's Annuity Pocket Guides. You'll get a feel for whether or not they're in the annuity business to stay by how comprehensive their pocket guides are. Do they explain products so that you can understand them? Do they have examples? This may sound trivial, but a pocket guide can sometimes be the window to other important elements of the annuity operation.

You may find that your prospect base for annuities is slightly more limited than your base for various forms of Life insurance policies, because annuities generally have a much narrower purpose: planning for retirement.

But there are several groups of people from whom you can draw prospects:

1. Those who want a better alternative to IRAs, 401 (k)s, Keoghs, and other plans whose advantages were severely curtailed by the Tax Reform Act of 1986. Annuities can be purchased outside of a tax-exempt retirement plan and still provide a tax-free buildup of earnings during the accumulation period. While the client gets no deduction for what is invested (chances are, under the new law, he or she wouldn't get a deduction for the IRA contribution, either), he or she can invest a virtually unlimited amount as opposed to the funding limits within retirement plans.
2. Municipal bond and jumbo CD holders. People with these types of investments may find the single-premium deferred annuity to be a better alternative, especially if they are using the CD and/or bonds to save for retirement. These clients have the required cash available, and may get a better return on their investment from the annuity. Even if the return is about the same, they receive the additional promise of an income they can't outlive.
3. Younger clients who want to make a long-term commitment to retirement income. An annual-premium or flexible-premium annuity might be more suited to these clients' needs. Younger clients may lack sufficient cash to make a large single payment.
4. Clients age 55 and older who are beginning to seriously look into their options for retirement income. Some of these clients, especially as they become more advanced in age, might be attracted to a single-premium immediate annuity, which begins making payments right away. It provides them with an orderly means of living off of accumulated capital and eliminates the risk of outliving financial resources. Other clients in the younger end of this age group may prefer a form of deferred annuity so that the investment has more time to build value.
5. Any client whom you know to be a conservative investor concerned about retirement. A fixed annuity might appeal to this type of client, who wants to be sure he or she will receive a minimum retirement income. On the other hand, aggressive investors who have taken a lot of risk in other areas may be attracted to the fixed annuity to counterbalance more speculative investments.
6. Married couples concerned that their income will provide a living for both of them until death. A joint-and-last-survivorship annuity is the most attractive option here.

Your major focus in selling annuities is almost always going to be retirement income, in one form or another. However, you can use different tactics with different groups of prospects, and you can target specific types of annuities for different people. Here are some suggestions for sales strategies:

1. Send out a direct mail letter to as many prospects in a week as you can follow up on. You can use Letter A1 in this campaign. Follow up on all return cards with a phone call to get the prospect into the office (Action Step 3). CSRs, or telemarketers if you use them, can make these calls. To get the prospect to agree to the meeting, use language patterned after the following:

1. How much income do you need in addition to Social Security, pension plan payments, and other investments?
2. Do you intend to share the income with anyone else?
3. How much can you afford in premium payments?
4. How will the annuity fit into your overall financial planning scheme?

1. Accumulated values and surrender values are illustrated for various years on a contract summary sheet. During the first few years, values may be less than the premiums paid. This serves to illustrate that annuities should not be purchased to solve short-run objectives; they are long-term, retirement-income-oriented investments.
2. Many illustrations will show the yield on gross premium at the end of ten years and at the time income payments are scheduled to begin. Since this takes into account the interest rates credited, all charges, and so on, you can use the yield on gross premiums to compare contracts. When contrasting annuities to other investments, point out that only annuities offer income and waiver of premium benefits, plus an income that cannot be outlived.
3. Values and income figures on annuity illustrations are usually shown in both 'guaranteed' and 'current' columns. The guaranteed column shows the minimum values the annuitant can expect, while the current column shows the values and income that would be paid if current interest and benefit rates for the contract held up during the period shown. Since you can't predict future interest rates, you need to stress that the annuitant has to decide for himself or herself how much to rely on current interest rates when making premium decisions.

1. Target jumbo CD holders for single premium annuities. Send out Letter A2 as a pre-approach letter (Action Step 2). During the follow-up phone call, ask the prospect the following questions:

1. At what rate of interest is your CD renewing?