Mini-Course Series - Annuities (Part 2)

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MINI-COURSE SERIES

ANNUITIES Part II

Copyright Š 2012 by Institute of Business & Finance. All rights reserved.


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FIXED-RATE ANNUITIES A fixed-rate annuity provides safety of principal plus a guaranteed return. The rate of return is guaranteed for a specified period. The investor is guaranteed a specified return, whether or not the insurer profits. The word “guaranteed” only applies to the timely interest payments of government securities, payment of face value of government bills, notes or bonds upon maturity, FDIC-insured CDs and certain provisions of a life insurance contract. For example, principal of a government security often fluctuates daily and purchase price is sometimes higher than face value. A fixed-rate annuity offers a set rate of return for a fixed period of time, both of which are guaranteed by the insurer. A fixed-rate annuity is similar to a certificate of deposit (CD) except for two important distinctions: [1] most CDs are backed by the Federal Deposit Insurance Corporation (FDIC) up to a certain dollar limit and [2] interest from CDs is not tax-deferred. Like a CD offered by a bank or savings and loan association, there are hundreds of insurers who offer fixed-rate annuities. You can buy CDs whose maturity ranges from one month up to 10 years; fixed-rate annuities have maturities ranging from 1-10 years. A bank offers CDs with different rates of return and maturity dates; the same is true with an insurance company offering fixed-rate annuities. Some banks offer rates higher than other banks; the same bank will have different rates depending upon the amount being deposited and the duration of the CD. The guaranteed rate offered by an annuity also varies among insurers and by the same insurer for the same reasons: length of the guarantee and amount deposited. The early withdrawal penalty associated with CDs can eat into principal. The penalty associated with a fixed-rate annuity cannot eat into principal with most contracts, regardless of how soon the investor cancels or cashes in the annuity. Some banks offer a CD liquidity feature that is penalty free; almost all fixed-rate annuities include a free withdrawal provision during the penalty period (described later). Finally, there is the issue of competitiveness. Some banks and insurance companies offer rates higher than their peers either because they have a greater need for the investor’s money, feel they can earn a higher return on the deposited funds or they require a smaller spread (profit). The table on the next page summarizes the differences between a CD and a fixed-rate annuity.

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Traditional Fixed-Rate Annuities vs. Bank CDs Feature Guaranteed return

Annuity 

CD 

Interest taxed each year

Penalty can eat into principal

FDIC insured

Excellent record of safety

Higher yield

Fixed-rate annuities can be defined according to how interest is credited. There are a large number of fixed-rate annuity designs; more will emerge. The nine most widely used fixed-rate annuity designs are: 1. 2. 3. 4. 5. 6. 7. 8. 9.

traditional interest-indexed equity-indexed bailout certificate stepped-rate guarantee market value adjusted bonus rate two-tiered

TRADITIONAL ANNUITY For a long time, investing in a fixed-rate annuity was easy to understand because most had a basic structure: a one-year guaranteed rate, a minimum guaranteed rate for the term of the contract and surrender charges. The contract holder had to have faith that the insurance company would offer a competitive rate for the second and subsequent years. Many insurers offered competitive rates throughout the annuity contracts’ term but a number of other insures did not. For example, if the annuity marketplace was offering 7% for new contracts but the contract owner received a notice his insurer was dropping the rate from 8% the first year to 5% the second year, the contract owner had no recourse. The investor either accepted the non-competitive rate or paid any remaining applicable surrender charge.

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Surrender charges for traditional fixed-rate annuities lasted anywhere from a few years up to 10 years; a few contracts imposed an indefinite penalty (in which case the only way to avoid a penalty was either death or annuitization). Several companies also offered an initial guaranteed rate lasting for multiple years, not just the first year. Still, even when there was a multiple-year guarantee, the surrender period could exceed the guarantee period. Traditional fixed-rate annuities still exist today but with a couple of important differences. First, the minimum guaranteed rate for the life of the contract is now 2-3% (versus 4% years ago). Second, the penalty period generally lasts as long as the initial rate guarantee, which now ranges from 1-10 years.

INTEREST-INDEXED ANNUITY One of the first popular alternatives to the traditional design was the interest-indexed annuity. An interest-indexed annuity guarantees a rate for one year or less; each subsequent rate guarantee is based on a well-known third party index, such as a 10year U.S. Treasury bond. The interest-indexed annuity owner is also assured of at least receiving a minimum annual guarantee set for the entire contract term. Like any other annuity, after the term ends, contract owners can cash out their contract and do whatever they like with principal and accumulated interest without incurring a surrender charge. The interest-indexed annuity is particularly appealing to investors who believe interest rates, and more specifically, the third-party reference index, will rise during the contract’s term. These investors are more concerned with what might happen to interest rates after the initial guarantee ends.

EQUITY-INDEXED ANNUITY Interest credited to an equity-indexed annuity (EIA) is based on the performance of an underlying bond or stock index; the S&P 500 is the most popular index used by EIAs. Interest is calculated as a percentage of the index’s gains, referred to as the participation rate.

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The participation rate generally ranges from 40-100% or more, depending upon other contract features (i.e., use of averaging, the cap rate, annual administration charges, general level of interest rates and contract term). The participation and cap rates are frequently the two most important concerns for the EIA investor. For example, the contract can have a 100% participation rate and a 7% annual cap rate. This means that if the underlying index is up 23% for the year (or any figure above 7%), the most credited to the investor is 7% for that year. The minimum guaranteed rate of most EIA contracts only guarantees the return of principal at the end of the term, which typically ranges from 3-8 years or more. Some EIAs have a minimum annual guaranteed rate in the 2-4% annually compounded range. However, since there is cost to the insurer for such a guarantee, upside potential is more limited than other contracts that only guarantee return of principal. EIAs generally have the longest penalty period of any annuity design. Advisors who are considering EIAs for their clients need to understand all factors that can limit upside potential (e.g., the underlying indexes used never include dividends since call options and not the actual index is being purchased). Equally important, the advisor should review the penalty period and structure as well as how contract liquidity works (e.g., is annuitization required in order for the investor to receive the full benefit). Because EIAs are the most complex type of fixed-rate annuity, they are covered in detail later.

BAILOUT ANNUITY The bailout design is very similar to the traditional annuity design, but with one important difference. The bailout annuity includes four interest rates: the initial rate guaranteed for 1-12 months, the renewal rate (which can be anything the insurer wants), the minimum guarantee rate (which was 4% many years ago but is now 2-3%) and the bailout rate. The bailout rate is established before the contract is issued and is typically 1-2% less than the initial rate. The insurer cannot change the bailout rate during the contract’s term. If any renewal rate is below the bailout rate, the contract owner is not forced to accept the lower rate. Instead, the investor can “bail out� and cancel the contract, walking away with principal plus accumulated interest without incurring any surrender charge. Once the surrender charge period ends (typically 3-5 years or more), the bailout rate becomes irrelevant.

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Because no one can predict interest rates, a bailout annuity design is more expensive for the insurer to offer. When interest rates are falling and renewal rates are lowered, the insurer could see massive redemptions if the bailout feature were invoked. One could make the case that this would not be likely because the contract owner may have few other options—if the insurer is dropping rates, chances are that other investments are also offering lower rates. Still, the potential costs of a bailout design mean fewer insurers offer this type of annuity.

CERTIFICATE ANNUITY Certificate annuities offer a guaranteed rate for exactly the surrender period. At the end of the term, frequently 1-3 years, the contract owner is sent a notice that spells out the guarantee for the next period. If the contract is not cancelled within 30 days of the notice, a new term and penalty period begin. Certificate annuities are sometimes called CD annuities because the renewal process is virtually identical. However, the advisor should not use the term “CD annuity” because the product is not backed or guaranteed in any way by FDIC. Some certificate annuities have durations of 5-10 years; they are referred to as “long-term guaranteed annuities” (LTGAs). A relatively new type of certificate annuity is the nonsurrenderable certificate annuity. As the name suggests, a non-surrenderable annuity cannot be liquidated during its term. Although they cannot be terminated, a number of these annuities have either a 10% annual penalty-free withdrawal or loan provision.

STEPPED-RATE GUARANTEE ANNUITY Stepped-rate guarantees are a relatively new design for annuities. Each year, the guaranteed rate increases. If the first year’s rate is 4.5%, the second year’s guaranteed rate might be 4.7%, 4.9% for the third year, 5.1% for the fourth year, etc.

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MARKET-VALUE ADJUSTED ANNUITY As interest rates fluctuate, so does interest credited to the contract owner of a market value adjusted annuity (MVA). Since the rate of MVA contracts adjusts, there is less risk to the insurer. Some interest rate risk remains with the insurer because most MVA contracts have a minimum floor rate that must be credited, regardless of rate drops. Since at least some interest rate risk is passed onto the contract owner, the insurer can offer a higher rate compared to other contract designs. Since there is less risk to the MVA insurer, reserve requirements are lower, resulting in savings to the insurance company. Because there is at least some risk transference to the investor, advisors who discuss this type of annuity with a client or prospect need to emphasize this potential downside. A number of MVA product designs increase the risk to the contract owner by not guaranteeing principal or a minimum interest rate. This increased risk means the investor could end up with little or no increase being credited during the entire term; it could also mean loss of principal (think what happens to the value of a long-term bond when interest rates increase substantially). Because of this lack of principal protection, MVA annuities that have no guarantees of principal must be registered with the SEC as a security and are not technically fixed-rate annuities. They are considered to be a variable annuity, even though they have a number of traits similar to fixed-rate contracts. The MVA annuity is designed for the investor who is willing to take on certain amounts of risk in the belief she will be rewarded with a higher interest rate. Since fixed-income principal drops in value when interest rates increase, investors who would normally be attracted to this investment would want to avoid this product if they believe rates were going to increase more than a couple of percentage points during the term.

BONUS RATE ANNUITY In order to attract annuity investors, a number of insurance companies have been offering bonus rate annuities since the mid 1990s. With a bonus rate annuity, the contract owner receives one rate the first year and then a lower rate thereafter. The first year’s rate is usually 2-3% higher than what is offered by competing annuities that do not include a bonus.

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There are two problems with bonus rate products. First, a number of investors believe the higher initial rate is the same rate applicable to the duration of the contract. Once they discover this is not true, it is too late. Any cancellation or surrender during the term is subject to a penalty. Second, the extra interest earned the first year is not really a “bonus”—someone has to pay for that bonus and that “someone” is the contract owner. Any credited bonus means later returns will be lower to offset the cost incurred by the insurer who paid the higher initial rate. Despite the reality of bonus rate annuities, this product design still remains very popular—apparently there are a number of investors who believe there is “a free lunch.” Some annuity issuers have taken the bonus rate annuity and altered it slightly by adding an amount at the end of the contract’s term. When the extra interest is credited at the end, it is called a bonus annuity. The SEC website compares two annuities, each purchased for $100,000. The first contract offers a 4% bonus credit (allowing $104,000 to be initially invested). The annual cost of the bonus is 0.5% (1.75% vs. 1.25%). Assuming a 10% annual return before expenses, after 10 years the value of the annuity without bonus credit is $231,360 versus $229,780 for the bonus annuity. The dollar difference in the example above becomes greater in the unlikely event the rate of return exceeds 10% a year. The bonus credit also becomes even less attractive the longer the compounding period. Furthermore, there are a number of ways the insurer may be able to take away the bonus credit: if early withdrawals are made or upon death if the annuity includes a life insurance benefit.

TWO-TIERED ANNUITY These annuities are called “two-tiered” because the contract receives one interest rate during the accumulation phase but that rate retroactively reverts to a lower rate unless the contract is annuitized. Investors believe they are being credited one rate but actually receive a much lower rate if they do not eventually annuitize. The annuitization requirement to get the higher rate is spelled out in the contract, but few annuity buyers ever read the agreement. Some states have banned the use of two-tiered annuities, a design that was popular with teachers and school administrators who used TSAs (tax-sheltered annuities) to fund their retirement account with pre-tax dollars.

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If you live in a state that allows two-tiered annuities, make sure the client understands the following: [1] the rate credited to the contract is only valid if the contract is annuitized at some time in the future, [2] the rate of return during the period of liquidation (annuitization) may be extremely low, making the overall return noncompetitive and [3] the length of time it takes for the entire contract to be liquidated may not be acceptable. With a two-tiered annuity, annuitization may be for a period certain such as 5-20 years, but most of these products require lifetime annuitization if the contract owner wants to lock in the “first tier” rates. Brokers are attracted to two-tiered annuities because they pay a high commission. Contract owners who choose to terminate a two-tiered annuity face a surrender charge that can be quite high.

THINGS TO DO  Your Practice The traditional fixed-rate annuity can be a substitute for a large portion of the conservative portion of a client age 60+. The different types of fixed-rate annuities described herein provide a creative alternative to a “plain vanilla” contract but usually at a price that makes such alternatives much less attractive. Think of the traditional fixed-rate annuity as an overlooked, and often superior, conservative asset class.  The Next Installment Your next installment, Part III, covers five topics: annuity death benefits vs. term insurance, long-term care rider costs, when variable annuities are appropriate, savings and retirement years plus charitable gift annuities. You will receive Part III 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.

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