MINI-COURSE SERIES
ANNUITIES Part I
Copyright Š 2012 by Institute of Business & Finance. All rights reserved.
ANNUITIES
1
ANNUITY DEFINITION An annuity is a contractual investment through an insurance company that offers the investor certain assurances. There are three ways in which an annuity can be defined: [1] how money is invested (fixed-rate or variable), [2] method of investment (single or multiple payments) and [3] when distributions commence (immediate or at some future date). Annuities are either qualified or nonqualified. A qualified annuity is used for retirement plans, such as a 401(k), pension plan or IRA. Most qualified annuities are funded with pre-tax (deductible contributions). Nonqualified annuities are always funded with after-tax dollars and can be purchased by virtually anyone. All annuities share the following characteristics:
Tax-deferred growth Distributions of growth/interest are taxed as ordinary income Distributions of principal from a non-qualified account are never taxed Annuitization is always an option Upon death, proceeds pass free of probate (if trust or person is named) Each annuity contract has an owner, annuitant and beneficiary The owner decides who will be the annuitant and beneficiary The same person can be the owner, annuitant and/or beneficiary All annuities are issued by an insurance company Annuities are sold by banks, brokerage firms and insurance companies Any guarantees are backed by the insurer Tax event for all non-qualified accounts is triggered if owner dies unless (surviving) spousal exception applies
Annuities are a risk management tool allowing one to fulfill certain needs, or at least increase their likelihood, because of their underlying guarantees. Annuities are a planning tool allowing the advisor to manage three types of risks: distributions, earnings and amounts available to heirs. For investors, the biggest selling points of an annuity are tax-deferred growth and certain guarantees. Generally, the biggest distinguishing factor is whether the annuity is fixedrate or variable. Fixed-rate annuities should be considered for part of the conservative portion of a portfolio since its rates are often higher than government securities and there is no reinvestment risk. Variable annuities with living benefits (discussed later) allow conservative investors to greatly increase their equity exposure.
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IBF | MINI-COURSE SERIES
ANNUITIES
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WHEN PAYMENTS BEGIN A deferred annuity has two phases: accumulation and distribution. The accumulation phase is from client purchase date until distribution phase. The distribution phase encompasses the period of time from when withdrawals are made until the annuity contract has a zero balance. With a deferred annuity, the client does not have to make any withdrawals during lifetime; the client also has the option of taking distributions either as a lump sum, periodic, sporadic, systematic or by annuitization (self-liquidation over three or more years, lifetime, joint lifetimes or until there is a zero balance). An immediate annuity begins making payments within one year of purchase; another name used to describe an immediate annuity is payout annuity. A deferred annuity has three values that may or may not be the same: cash value, annuity value and surrender value. Cash (accumulation) value is the dollar amount used to compute growth. Generally, it is client principal plus any growth previously credited, less withdrawals; in the case of qualified annuities, the formula would be the same but any unpaid loan interest would also have to be subtracted. The annuity value is only important if the contract is annuitized. The annuity value is what is used to calculate the payout factor if annuitization is requested (distribution of principal and growth/interest). Surrender value is cash value minus any remaining surrender charges; in certain cases, there could also be a market value adjustment that could either increase or decrease surrender value. When there is a dividend or capital gain within a variable annuity, the value of its corresponding accumulation unit is increased to reflect such an event; the number of units remains the same and there is no distribution or taxable event.
LIFETIME INCOME Annuities are the only investment vehicle with guaranteed lifetime income. In return for lifetime income, the investor gives up principal in return for monthly or annual income; the shorter the life expectancy, the higher the payments. As you can see from the next table, the younger the investor, the less guaranteed annual income (e.g., $8,000 a year for life for a male age 65 vs. $10,600 a year for life for a male age 75).
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ANNUITIES
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2012 Annual Lifetime Income From A $100,000 Immediate Annuity age
55
60
65
70
75
80
85
male
$6,600
$7,300
$8,000
$9,200
$10,600
$13,300
$16,300
female
$6,300
$6,700
$7,400
$8,200
$9,500
$12,000
$15,000
m&f*
$5,900
$6,200
$6,700
$7,300
$8,400
$10,000
$12,600
* both spouses are same age; payments remain level as long as either spouse is alive
Although not commonly done, an annuity can be structured so that each year the income stream is adjusted by inflation (CPI). As the table below shows, this is not usually recommended since payments are initially up to 40% lower (e.g., female age 55: $3,800 vs. $6,300).
2012 Annual Lifetime Income From A $100,000 Immediate Annuity [With Annual CPI Increase] age
55
60
65
70
75
80
85
male
$4,200
$4,800
$5,700
$6,700
$8,400
$10,100
$12,600
female
$3,800
$4,400
$5,100
$6,100
$7,500
$9,200
$11,900
Projecting life expectancy can be important when deciding whether or not lifetime annuitization (income) for a portion of one’s portfolio should be considered. Assuming average or better-thanaverage health, the older the investor, the more an immediate annuity makes sense—if there are no heirs. Someone younger than 65 should also look at other income-generating methods, such as a systematic withdrawal plan with a balanced (stock/bond) mutual fund.
Life Expectancy in Years [smokers and nonsmokers] age
40
50
60
65
70
75
80
85
90
male
38
29
21
17
13
10
7
5
3
female
42
33
24
20
16
13
10
7
3
Factors Influencing Life Expectancy Percentage
Factor
Percentage
Factor
50%
Lifestyle (e.g., smoking, diet, etc.)
16%
Environment (e.g., water quality)
24%
Biology (e.g., genetic disposition)
10%
Medical Care
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IBF | MINI-COURSE SERIES
ANNUITIES
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Predicting Future Returns and Current Risk Levels The term used to describe the relationship between an investment’s return from one year to the next is serial correlation. There is zero correlation between S&P 500 returns from one year to the next; there is only a 1% serial correlation between the total return of a long-term government bond from one year to the next; 99% of the total return cannot be accurately forecast from one year to the next. Thus, historical returns are incredibly misleading if they are used to predict future returns. Standard deviation, which is the most widely used measurement for risk, can also fluctuate dramatically from one year to the next.
Standard Deviation for Select Years Year
S&P
Sm. Stocks
LT Bonds
MT Bonds
Annuities
2011
18%
24%
15%
4%
0%
2010
20%
25%
17%
3%
0%
2009
29%
42%
14%
5%
0%
2008
14%
20%
23%
7%
0%
2007
10%
12%
8%
5%
0%
2005
8%
16%
10%
4%
0%
2001
18%
35%
10%
5%
0%
2000
16%
40%
7%
3%
0%
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IBF | MINI-COURSE SERIES
ANNUITIES
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ANNUITY HISTORY Annuities, in one form or another, have been around for over two thousand years. In Roman times, speculators sold financial instruments called annua, or annual stipends. In return for a lump sum payment, these contracts promised to pay the buyers a fixed yearly payment for life, or sometimes for a specified period of term. The Roman Domitius Ulpianus was one of the first annuity dealers and is credited with creating the first life expectancy table. During the Middle Ages, lifetime annuities purchased with a single premium became a popular method of funding the nearly constant war that characterized the period. There are records of a form of annuity called a tontine. This was an annuity pool in which participants purchased a share and, in turn, received a life annuity. As participants died off, each survivor received a larger payment, until finally, the last survivor received the remaining principal. Part annuity, part lottery, the tontine offered not only security but also a chance to win a handsome jackpot. During the 18th century, many European governments sold annuities that provided the security of a lifetime income guaranteed by the state. In England, Parliament enacted hundreds of laws providing for the sale of annuities to fund wars, to provide a stipend to the royal family and to reward those loyal to it. Fans of Dickens and Jane Austen will know that in the 1700s and 1800s, annuities were all the rage in European high society. Annuities owed this popularity among the upper class to the fact they could shelter annuitants from the "fall from grace" that occurred with investors in other markets. The annuity market grew very slowly in the United States. Annuities were mainly purchased to provide income in situations where no other means of providing support were available. Few people saw the need for structured annuity contracts to guarantee themselves an income if they could rely on support from their extended families. Annuities were mostly purchased by lawyers or executors of estates who needed to provide income to a beneficiary as described in a last will and testament. This all began to change at the turn of the 20th century, as multi-generational households became less common. The Great Depression was especially significant in the history of annuities. Until then, annuities represented a miniscule share of the total insurance market (only 1.5% of life insurance premiums collected in the US between 1866 and 1920). During the Great Depression, investors sought out more reliable investments in order to safeguard themselves from financial ruin. With the economy less stable than it had ever been, many individuals looked to insurance companies as a haven of stability in what seemed a sea of anything but.
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IBF | MINI-COURSE SERIES
ANNUITIES
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THINGS TO DO Your Practice Contact income oriented prospects and clients. Show them the kind of income stream (8.0% for a 65-year old male) that can enjoy by annuitization of a fixed-rate annuity; make sure it is understood that guaranteed income is maximized if there is no donative intent. Also point out the benefits of using a fixed rate annuity (e.g., no reinvestment risk, account value can only increase, zero standard deviation during guarantee period, etc.). The Next Installment Your next installment, Part II, covers 10 topics: fixed-rate annuities, traditional annuities, interest-indexed, equity-indexed, bailout, certificate, stepped-rate guarantee, market-value adjusted, bonus rate and two-tiered annuities. You will receive Part II in a few days. Learn Are you ready to take your practice to the next level? Contact the Institute of Business & Finance (IBF) to learn about its designation programs: o o o o o
Annuities – Certified Annuity Specialist® (CAS®) Mutual Funds – Certified Fund Specialist® (CFS®) Estate Planning – Certified Estate and Trust Specialist™ (CES™) Retirement Income – Certified Income Specialist™ (CIS™) Taxes – Certified Tax Specialist™ (CTS™)
IBF also offers the Master of Science in Financial Services (MSFS) graduate degree. For more information, phone (800) 848-2029 or e-mail adv.inv@icfs.com.
PART I
IBF | MINI-COURSE SERIES