INSU 3315 –

Life and
Health
Insurance

Chapter 4: Annuities
COLLEGE OF BUSINESS
Center for Insurance & Risk Management Dr. Yao
Preparing Students for Lifetime
Careers
Learning Objectives

4.1 What is an annuity

4.2 Why people buy annuities
4.3 Parties to an annuity
4.4 Two phases of an annuities
4.5 Classification of annuities
4.6 Accumulation options
4.7 Distribution of proceeds or payout options
4.8 Annuity provisions
4.9 Annuity taxation
What is an Annuity?
An annuity – a periodic payment that continues for a fixed period
or for the duration of a designated life or lives.

An annuity provides financial protection against the risk of living

too long and being without income during retirement.
Two main objectives of an Annuity
To accumulate retirement assets on a tax-deferral basis;
*if you want to save more money

To convert retirement assets into a stream of income you

cannot outlive
*annuities also provide a unique death benefit.
Phases of an Annuity
Accumulation Phase (savings)
Annuity premiums, less any applicable charges, accumulate in the
contract on a tax-deferred basis until the annuity starting date
(payout) (premiums and interest growth)

Distribution Phase (withdrawal/payout/income phase)

The time the value of the annuity is converted into a stream of
income (annuitized)
Parties to an Annuity
Insurance company – the entity that guarantees the contract benefits.
*Financial strength and stability of the insurance company are
important.
Policy owner – the individual or entity that contributes the funds
*They typically have the right to terminate the annuity, to gift it to
someone else, to withdraw funds from it, and to change the annuitant
or beneficiary.
Annuitant – the individual whose life (mortality) is used to determine
the payments during the payout phase (may or may not be the same
person as the owner).
Beneficiary – the individual or entity that receives any proceeds
payable on the death of the annuitant.
Features of an Annuity
Tax deferral on investment earnings
• Investment earnings in annuities aren’t taxable until you
withdraw money.
• There are no limits on the amount you can put into an annuity.
• The minimum withdrawal requirements for annuities are much
more liberal
Protection from creditors
Generally, the most that creditors can access is the payments as
they’re made.
Features of an Annuity
An array of investment options, including “floors”
Many annuity companies offer a variety of investment options.
Annuity companies have created various types of “floors” that
limit the extent of investment decline from an increasing
reference point.
Tax-free transfer
Variable annuities have no tax consequences if you change how
your funds are invested.
Under rebalancing, you shift your investments periodically to
return them to the proportions that you determine represent the
risk/return combination most appropriate for your situation.
Features of an Annuity
Lifetime income (guaranteed)
A lifetime immediate annuity converts an investment into a stream of
payments that last as long as you do.
• Your investment;
• Investment earnings;
• Money from a pool of people in your group who do not live as long as
actuarial tables forecast.
Benefits to heirs
A “guaranteed period” with the immediate annuity – payments till the
end of the stated guaranteed period.
Annuity benefits that pass to beneficiaries don’t go through probate and
aren’t governed by your will.
Annuity Classifications
Number of lives covered
• Single life
• Joint and survivor
Time benefits begin
• Immediate – benefit begins immediately after purchase
• Deferred – benefit deferred for several years
Premium payment method
• Single premium
• Installment payments – fixed or flexible premiums
Annuity Classifications
Tax treatment
*whether qualified or non-qualified, accumulations are on a tax
deferred basis.
Non-qualified/after-tax annuities – annuities purchased outside
qualified pension plans; can be purchased by any individual or
entity

Qualified/pre-tax annuities – provisions of the IRS code pertaining

to qualified retirement plans permit annuities used to accumulate
money in such plans to receive tax-favored treatment of premium
payments; such premium payments (contributions) to the account
are tax deductible
Types of Annuities
Fixed Annuities – pays periodic income payments that are
guaranteed and fixed in amount.

1. Accumulation phase (deferred annuity)

• Principal is guaranteed (subject to surrender charges);
• Minimum guaranteed interest rate;
• Interest growth is tax-deferred;
• Death benefit
Types of Annuities
Fixed Annuities
2. Distribution phase (deferred/immediate annuities)
• Annuitization – guaranteed income for life or a specific period of
time.
With qualified annuities the entire distribution is subject to ordinary
income tax;
For non-qualified annuities, part of each annuitization payment is tax-
free return of premium and part is subject to ordinary income tax.
• Partial income withdrawals - fully taxable as ordinary income until
the interest earned has been taxed, then tax-free withdrawal of
premium, a 10% penalty may apply if withdrawal is taken prior to
age 59 1/2
Types of Annuities
Fixed Annuities
3. Regulation
• Regulated by the state department of insurance;
• Sales person must have a valid life insurance license to sell
fixed annuities
Types of Annuities
Variable Annuities – pays a lifetime income, but the income payments
vary depending on common stock prices.
*the fundamental purpose of a variable annuity is to provide an inflation
hedge by maintaining the real purchasing power of the periodic
payments during retirement.
1. Accumulation phase (deferred annuity)
• Annuity owner assumes investment risks, including loss of principal;
• Growth potential through market participation;
• Annuity owner can choose investments plus guaranteed interest
accounts;
• Optional income riders (GLWB);
• Death benefit
Types of Annuities
Variable Annuities
2. Distribution phase (deferred/immediate annuity)
• Annuitization – same as fixed annuities;
• Partial income withdrawals – same as fixed annuities
Types of Annuities
Variable Annuities
3. Regulation
• Sale of variable annuity products, which are classified as
securities, is regulated by the state department of insurance
and the Securities and Exchange Commission (SEC) through
the Financial Industry Regulatory Authority (FINRA);
• The sales person must have a valid life insurance license for
the states where they do business and they must also have a
registration with FINRA (Series 6 or Series 7 license)
Types of Annuities
Indexed Annuities – an equity-indexed annuity is a fixed,
deferred annuity that allows the annuity owner to participate in
the growth of the stock market and also provides downside
protection against the loss of principal and prior interest earnings
if the annuity is held to term.
1. Accumulation phase
• Principal is guaranteed and protected against financial market
declines;
• Indexed interest rate credited is based upon a company-
specific formula applied to changes in one or more linked
indexes subject to a maximum rate of interest;
Types of Annuities
1. Accumulation phase
• Indexed interest rate crediting methods
Cap rate – insurance company may impose a maximum rate of
interest that can be earned in a crediting period;
Participation rate – insurance company decided the percentage of
participation in the growth rate of the index; may be combined
with cap rate;
Spread – insurance company may impose a fee (2%) before the
annuity is credited
• Optional income riders;
• Death benefit
Types of Annuities
2. Distribution phase (deferred and immediate annuity)
• Annuitization – same
• Partial income withdrawals – same
3. Regulation
Sales are regulated by the state department of insurance; sales
person must have a valid life insurance license to sell indexed
annuities.
Policy Provisions
Age Restrictions
1. Issue ages
Age 85 is typical, although a few companies will issue policies up to age 95
*most contracts will have maximum age limits over which a contract cannot
be issued
Some contracts impose a lower maximum age for the annuitant than the
owner and some contracts only impose maximum age requirements on
annuities that will be paid out over the annuitant’s lifetime
2. Maximum age for benefits to begin
The annuitant must begin benefits before reaching the maximum age stated
in the contract; this is not the same as the requirements imposed by the
IRS on qualified plans
Policy Provisions
Surrender Charges (deferred sales charges)
1. Charges are designed to make moving money out of the
annuity less attractive to the owner.
2. Charges, expressed as a percentage, are usually applied to a
surrender (full or partial) made within a certain number of
years; many annuity contracts waive the charges in the event
of death or disability; also, many annuity contracts allow a
free 10% of account value once a year.
Policy Provisions
Optional Riders: Living benefit riders
1. Guaranteed lifetime withdrawal benefit (GLWB) –
regardless of stock market or index performance, the entire
principal invested plus interest earned will be returned to you
over your lifetime through withdrawals of a fixed percentage
of the account even if the account value is depleted;
2. Guaranteed minimum income benefit (GMIB) – after a
vesting period, the rider guarantees a minimum income
benefit, regardless of market or index performance. If the
value of the contract grows, the stream of income may be
higher, but it can never be lower than the guaranteed amount.
Policy Provisions
Optional Riders: Living benefit riders
3. Guaranteed minimum accumulation benefit (GMAB) –
after a specified period, typically 10 years, the value of the
annuity will be equal to or greater than the guaranteed
accumulation amount.

*These living benefit riders are optional and require payment of

an additional fee.
Accessing the Cash Value of
an Annuity
Annuitization
• Straight life – lifetime income payments guaranteed until the
annuitant’s death. No beneficiary.
• Life and refund certain – lifetime income payments until the
annuitant’s death. If total income payments received by the
annuitant are less than the account value of the annuity, balance
is paid to the annuitant’s beneficiary either in a lump sum or in
installments.
• Life and period certain – lifetime income payments guaranteed
until the annuitant’s death. If annuitant dies prior to the end of
the minimum period certain (10 or 20 years) payments continue
to the beneficiary for the remainder of the guaranteed period.
Accessing the Cash Value of
an Annuity
Annuitization
• Joint and survivorship life – lifetime income payments for
two or more annuitants income payments continue until the
death of the second annuitant.
• Joint and survivorship life with period and refund certain
• Joint and survivor life with period certain
Accessing the Cash Value of
an Annuity
Simple Systematic Withdrawals
• Set amount – the annuity owner can sometimes elect to
withdraw a set amount each month or year without any
contract fee or surrender charges being applied.
• Living benefits – allows to receive a percentage, usually 4% -
6%, of your original investment for as long as you live. These
benefits are usually age based so you may be able to take out a
greater percentage of your original investment if you are older.
Lump sum cash out
Income Tax Aspects
Premium payment
• Premiums paid into a non-qualified annuity are generally not
deductible;
• Premiums paid into qualified annuities, such as Tax-Sheltered
Annuities (TSAs) and IRAs or Keogh plans funded by annuities,
are deductible subject to IRS rules.
Accumulations
For non-qualified annuities, the interest credited to an annuity
each year is tax deferred. Tax would only be assessed on the
interest portion of the benefit.
Income Tax Aspects
Loans
• Amounts received as loans or as value of part of an annuity
contract pledged or assigned to cover a loan are taxable.
• Amounts assigned from the annuitant to another individual are
still taxable as income to the original annuitant.
Income Tax Aspects
Then percent premature distribution penalty tax
• Tax is imposed to discourage the use of annuity contracts as
short-term tax-sheltered investments;
• The 10% tax applies to the portion of any payment that is
taxable;
• The tax is imposed on taxpayers under age 59 ½ who receive
distributions from annuities.
Income Tax Aspects
Withdrawals
Withdrawals are received as interest out first. Therefore,
payments (until all interest is paid out) are subject to income
taxation as ordinary income in the year in which payments are
received. In addition,
• For persons under age 59 ½, there is also a tax penalty of 10%
of the taxable amount received;
• For persons over age 59 ½, the tax penalty does not apply.
Income Tax Aspects
Taxation of annuity benefit payments
• For a non-qualified annuity, payments are considered to be part
principal (cost basis) and part interest; calculation is done by
the insurance company and is called the “exclusion ration”
• For a qualified annuity, the entire payment is taxable as income
in the year it is received since a qualified contract has had the
benefit of a tax deduction.