CHAPTER ONE - WHAT ARE ANNUITIES

(NOTE:  The use of the male gender, i.e. “he,” “his,” “him” etc., is used to designate a person of either sex for simplicity purposes, as having to refer to “he/she,” “him/her,” is rather clumsy. )

 

“An annuity is a contract sold by insurance companies that pays a monthly (or quarterly, semiannual, or annual) income benefit for the life of a person (the annuitant), for the lives of two or more persons, or for a specified period of time.  The annuitant can never outlive the income from the annuity.  While the basic purpose of life insurance is to provide an income for a beneficiary at the death of the insured, the annuity is intended to provide an income for life for the annuitant.  There are variations in both the way that payments are made by a buyer during the accumulation period, and in the way payments are made to the annuitant during the liquidation period.

 

The following chart shows the various types of annuities by classification¹:

 

 

 

An annuity may be bought by means of installments, with benefits scheduled to begin at a specified age such as 65; or, it may be bought by means of a single lump sum, with benefits scheduled to begin immediately or at a later date.  No physical examination is required.” (Dictionary of Insurance Terms, Third Edition)

 

 

Simply put, an annuity is defined as a policy contract that agrees to pay the insured a regular income over a specified number of years.  Often called “life insurance in reverse” because while life insurance protects against loss by premature death.  Annuities, on the other hand, protect against “living too long.”  However, most annuities have some sort of death benefit.  By assuring continued payments for a specified or unlimited number of years, annuities guarantee that the insured will not deplete his or her source of income.

 

The time period over which the insurance company promises to provide income varies by type of contract is logically called the Annuity Period.  The contract may specify an exact number of years or the individual’s lifetime (an unspecified number).

 

The person who purchases the annuity is the owner.  The person who received payments from the annuity is the annuitant.  The annuitant may or may not be the contract owner.

 

Annuities may be written on an individual, joint or group basis.  The most common is the individual annuity that is usually purchased for retirement purposes.  The “Joint and Survivor” annuity is also a common form for married persons.  With this type of annuity, there are two persons insured and payments are guaranteed to continue to the surviving spouse upon the other’s death.  Annuity payments can be either the same or different amount, usually designated as a percentage of the original amount (discussed in more detail later).  Group annuities are generally part of a group pension or similar employee benefit plan.

OWNERSHIP OF AN ANNUITY

When the owner of an annuity enters into an agreement they must always understand all of the terms to the best of their ability.  If there are additions, withdrawals, or a complete liquidation to be made, there may be restrictions or penalties.

 

The contract owner can be an individual, couple, trust, corporation, or partnership.  The only requirement is that the owner must be an adult or legal entity.  A minor can be the owner as long as the policy lists the minor's custodian (example:  “James Jones, as custodian for the benefit of Johnny Jones").  Since the contract owner controls this investment, the owner has total control, and can give the contract to anyone, or will give part or the entire contract to anyone or any entity at any time.

THE ANNUITANT

The most difficult party to an annuity for a person to fully understand is the annuitant.  The best way to understand this party to an annuity would be to compare it to the functions of a life insurance policy.  When a life insurance policy is issued, the person insured is named on the contract and continues as the insured until the owner of the policy either terminates the contract or does not make any required premium payments - or, of course, the insured dies.

 

With the annuity, the terms remain in force until the contract owner makes a change or the annuitant (the person named in the contract as annuitant) dies.  Therefore, the annuitant resembles the insured in a life insurance policy.  But with an annuity, the death of the annuitant does not necessarily mean the contract is about to terminate.  Even though every annuity contract must designate an annuitant, the annuitant has no voice or control over the investment or its disposition.  If the contract is a Variable Annuity, and if the annuitant dies, this may create certain insurance company guarantees.

 

Annuitants are often called the "measuring life."  This means that the length of time that the contract covers must have a specific time frame.  The annuitant is then used as the time frame that is considered and referred to by the contract.  Just like in life insurance, the annuitant has no voice or control over the contract. The annuitant can benefit from an annuity ONLY when it “annuitizes.”   The annuitant, by itself, cannot make withdrawals or deposits, change the names of the parties to the agreement, or terminate the contract.

 

The person named as annuitant can be any person so designated by the annuity, with the only restriction being that is must be an actual living person under a specified age, and not a trust, business, corporation, etc.  The maximum age of the proposed annuitant depends on the requirements of the insurance company – usually the annuitant must be under age of 75 when the contract is first executed.  It is of prime importance that the investment (contract) stay in force after the annuitant reaches this maximum age.²

 

Generally, the contract owner may change the annuitant at any time provided the annuitant is alive when the contact was originally executed.  Some contracts allow for the contract owner to name a co-annuitant.  By naming a co-annuitant, the contract could last longer because any “forced” annuitization or the termination of the contract could possibly be postponed until the death of the second annuitant.  The co-annuitant can be compared to a “second-to-die” life insurance policy, as the death of one annuitant will not force distribution of the annuity.  Naming a co-annuitant means the death of one annuitant will not trigger a possible forced distribution. 

 

Only a small number of insurers include a co-annuitant option as part of the annuity application.

 

Some annuity contracts require a distribution or “orderly liquidation” of the funds, once the annuitant reaches a certain specified age - typically 80 or 85.  The death of an annuitant may require liquidation within a specified period, usually five years.

AGE OF ANNUITANT

Regulations are rather detailed as to who can purchase an annuity and for whose benefit, keeping in mind the contract law that a contract entered into by a minor can be voided by such minor. 

 

California regulations state that (a) a minor under age 18 may enter into a valid contract for life or disability insurance, or annuities, (b) those under age 16 can purchase life or disability insurance or annuities with the written consent of their parent or guardian.  In respect to benefits, a minor under the age of 18 may give valid instructions as to any money that has accrued or payable under the terms of the contract, but only with the written consent of a parent or guardian.  The regulations also state that any contract that is made by a minor under age 18 that can result in the personal liability for assessment, may only be issued with the written assumption of such liability by a parent or guardian. ^12B

 

In actual practice, annuities are generally issued with maximum ages of 85 and annuitization at age 90 or 95, with some offering maximum annuitization age of 100.  Age 85 is also often used for both purposes as that is the law in Pennsylvania.  For non-qualified products the youngest issue age is usually -0-, but the minimum age usually is only mentioned for Equity Index Annuities.^41,46,49

THE BENEFICIARY

 

To use an analogy, in a life insurance policy, the beneficiary has no “status” until the death of the named insured.  In an annuity, the beneficiary has no “status” until the death of the annuitant.  Similarly, the beneficiary of an annuity has no control of the policy and has no say in the management of the policy.  The annuitant benefits from an annuity only when the annuitant dies.

 

The beneficiary can be either an individual, or a trust, corporation or partnership.  There does not have to be any relationship between the beneficiary and the annuitant – indeed, they could conceivably be (but highly unlikely) total strangers.  The application form used for an annuity allows the owner to state multiple beneficiaries, and to designate the percentage of each beneficiary if so desired.

 

Frequently, one spouse would be the owner of the contract, and the other spouse would be the beneficiary.  With some companies, co-ownership is allowed, thereby allowing both spouses to be owners.  They can be quite valuable in case the annuitant dies as the annuity proceeds would not go to a beneficiary as long as one of the spouses was still alive.

 

Generally, a single person (or widow or widower) will designate themselves as the owner of the contract and also the annuitant, naming another party as the beneficiary (such as a church, charity, etc.).  By doing this, the person has complete control over the investment during their lifetime, and upon their death, the annuity proceeds will automatically pass to the intended heir.

 

Since the owner of the contract can change the beneficiary at any time, they do not need to notify a listed beneficiary that they have been so designated, or indeed, even tell them if they are removed as beneficiary.

MULTIPLE TITLES

When the original investment(s) is/are made, the owner(s), annuitant, and beneficiary(s) must be so stated.  As stated above, only the annuitant has to be a natural person.  The person can hold more than one “title.”  For instance, they could be the contract owner and beneficiary of the same contract.  It is also possible that the annuity owner, annuitant and beneficiary are the same person.  It should always be remembered that a non-person entity (such as a corporation, partnership, living trust, etc.) can only be specified as contract owner and/or beneficiary.  The annuitant must be a living individual under a certain age.

HOW THE CONTRACT IS "DRIVEN"

 

Most annuities are considered as "annuitant-driven," i.e., if the annuitant reaches a certain age, died, or became disabled, certain provisions of the annuity would govern.  Some of these provisions could waiver any penalties enacted by the insurer, or the death benefit, IRS penalty, and/or the required annuitization or distribution of the contract would go into effect, depending upon the situation of the annuitant (such as the contract owner dying, reaching a certain age, or becoming disabled).  Some annuities state that certain provision can come into being if the owner, co-owner, or annuitant dies, reaches the age of annuitization, or becomes disabled.  This flexibility makes the annuity more appealing in some circumstances.

WHEN DO BENEFITS BEGIN?

 

There are two basic types of annuities in respect to when benefits start (when the annuity “annuitizes”) – immediate and deferred.

IMMEDIATE ANNUITY –START PAYING NOW

With an immediate annuity, annuity payments will commence after a predetermined “period.”  The period can be one year, for instance, in which case the first benefit payment will be one year after the purchase of the immediate annuity.  Payments can be monthly, quarterly, semi-annual or annual.  If the period is one month, annuity payments start one month after purchase.

DEFERRED ANNUITY-START PAYING LATER

With annuitization, the payment period is scheduled to begin at some future date.  The period when the contract annuitizes, is called the maturity date.  Conversely, for definition purposes, the period prior to the maturity date is called the accumulation period.  Further, the period following the maturity date during which payments are made is the liquidation or distribution period.

 

If death occurs before the annuitization period as stated in the contract, the cash value paid to the annuitant’s beneficiary would equal the amount of premiums paid in.  However, most contacts provide for payment to the beneficiary of at least the amounts paid in - plus interest and regardless of sales charges.

 

The purchaser of a Deferred Annuity is permitted to alter the date that payments are scheduled to begin but within certain conditions that are plainly stated in the annuity.

 

HOW ARE ANNUITIES PURCHASED?

MARKETING

Prior to the 1970s, annuities were marketed by traditional insurance agents, most of whom were career agents.  During the 19970s and early 1980s, stockbrokers increased their distribution of annuities, followed by growth in brokerage general agency distribution, followed by growth by banks marketing annuities.  In today’s market, all marketing and distribution systems are doing well.

A TYPICAL ANNUITY OWNER

The Gallup Organization surveyed over 1,000 nonqualified annuity owners in 2004 for the Committee of Annuity Insurers – an organization of life insurance companies that issue annuities.  Gallup identified the nonqualified annuity-owners by several characteristics³:

1. Interestingly, the average of these annuity owners was 65.
2. 52% of these annuity owners were male, 48% female.
3. 63% of annuity owners of these contracts were married, 20% were widowed.
4. Of owners of nonqualified annuities, 56% were retired, 38% were employed (either full-time of part-time).
5. 55% of owners had “moderate” household income, described as between $20,000 and $74,999.  62% had total annual household incomes under $75,000.
6. 85% of the owners purchased that first annuity when they were less than 65 years old. Average age at which owners purchased their first annuity was 50.

PREMIUM PAYMENTS

The specific premium amount depends on several factors, primarily the length of the guaranteed benefit payment period.  The “Straight life” (discussed later) annuity offers maximum income per dollar of outlay.  Obviously, the reason for this is that some annuitants will die prematurely, or in the early part of the annuitization, thereby restricting the total amount of payout.  Period certain and refund options provide less income per dollar of outlay, as the element of mortality does not enter the equation.

 

The interest the company earns on investments is an important factor in determining annuity premiums.  The higher the interest, the more income per dollar of outlay.  During the discussion of Equity Indexed Annuities, the effect of the company’s investment portfolio is extremely important.  Obviously, the higher the investment returns the lower the premiums to the annuitants.

 

The third factor is the expenses of the insurer.  If the insurer has high expenses (such as high commissions and overrides), the higher the premium to the policyholder.  In other words, the lower the expenses, the lower the premiums paid to the insurer which is required by the insurer to pay all claims and satisfy their stockholders.

 

 

This (annuity) concept may be difficult for people used to Certificates of Deposit and other savings vehicles to comprehend.  As an insurance product, annuities are calculated on the participation of many people.  Thus, when they start receiving annuity payments, those funds will come from a pool of funds that provides this income to those who live long enough to receive it.  The $74.26 represents the insurance benefit that annuitants that survive to age 66 would receive, based on calculations on the number of annuitants that are likely to die that year.  Therefore, the death benefit to surviving annuitants will grow larger each year during the liquidation period.  If the annuitant lives long enough, both principal and interest eventually will be exhausted, and entire payment will come from the insurance benefit.

HOW ARE ANNUITY PREMIUMS PAID?

Single Premium immediate annuity premiums are paid when the contract is signed, hence the term “lump sum payments.”  The funds for the payment of premiums can come from a variety of sources such as Employee profit-sharing plan, Savings Accounts, Cash Value of life insurance policy or sale of home or property, etc.

 

In today’s market, many annuities are purchased as the result of an IRA, 401(k) or 403(b) rollover.  When this is done, it is extremely important that it be a “Section 1035” exchange, i.e. that it not be a taxable exchange unless, for some reason, the customer wants to pay taxes on the amount of the rollover at that time.  The insurance company will furnish the papers that must be executed for such a rollover to exist and as discussed elsewhere in this text, the funds must be automatically transferred to the new annuity.

 

Periodic Level Premiums is a typical payment method of deferred annuities.  The annuitant pays equal premium amounts at regular intervals, until the benefits are scheduled to begin.  Some individuals choose this option as it is similar to making deposits into a regular savings type account.

 

Periodic Flexible Premiums is a premium payment method that is more “in tune” with today’s investment world.  The annuitant pays the premiums over a period of time, until they are paid off.  Since the premiums are flexible, they appeal to those who want flexibility in the timing and amount of premium payments and are particularly attractive to those who want a program in which they can vary the amounts they save each year.  This also appeals to those who earn commissions, or other types of irregular income such as actors, fruit-truck drivers, artists, etc., not to mention families with growing children.  As long as the annuity remains in effect, funds will continue to accrue interest.  The principal disadvantage is that the actual amount of annuity benefit cannot be determined in advance, which may be essential in financial planning.

 

MAXIMUM PREMIUM ALLOWED TO BE COLLECTED

Insurance companies that issue annuities are restricted as to the amount of premiums paid in advance that they are allowed to collect.  This is important inasmuch as Variable Annuities, and to some extent, Equity Indexed Annuities, allow other than fixed payments.  Obviously, in order for the insurance system to work, an insurer may accept such funds, but the funds may not exceed the sum of future unpaid premiums on any policy or the sum of 10 such future unpaid annual premiums if such sum is les than the sum of future unpaid premiums.  These regulations do not disallow the rights of an insurer to accept funds when there is an agreement that such accumulation of funds will be used for purchasing annuities at a future date.^3A

 

HOW LONG WILL BENEFIT PAYMENTS CONTINUE?

ANNUITY CERTAIN (PERIOD CERTAIN)

An Annuity Certain specifies the number of benefits payments of a set amount.  This option will guarantee a minimum amount that the insurance company will pay on an annuity.  The annuity has a Death Benefit that provides for payment to be made to the designated beneficiary upon the annuitant’s death and will continue as long as the beneficiary lives.  In effect, this annuity says that it will pay the benefits remaining of the period certain to the beneficiary.  However, if the annuitant should survive the period certain, then the annuity performs as a Life Annuity.

.

 

“A Life Annuity Certain is an annuity that … guarantees a given number of income payments whether or not the annuitant is alive to receive them.  If the annuitant is living after the guaranteed number of payments has been made, the income continues for life.  If the annuitant dies within the guarantee period, the balance is paid to a beneficiary.  For example, under one common contract, a life annuity certain for 10 years, income payments are guaranteed for a minimum of 10 years.  If the annuitant dies after receiving two years of payments, the beneficiary would receive the remaining eight years of income.  An annuitant who lives out the 10 years would receive income payments for life, but there would be none available to a beneficiary.”⁴ 

LIFE ANNUITIES (STRAIGHT LIFE ANNUITIES)

This is the most common type of annuity.  The simple “Straight Life Annuity” provides for guaranteed periodic payments that terminate upon the death of the annuitant.  Once the annuitant dies, the contract is fulfilled and no payments are made.  This type of annuity does not guarantee that the annuitant will receive payments equal to the amount paid as premiums on the contract.  If the annuitant lives a long time, they will recover more than all of the premiums they have paid; if they die soon after annuitization, the insurance company will only pay the benefits up until the time of death.

 

In the event the annuitant dies during the accumulation period (i.e. the time that payments are being made on the annuity, but prior to annuitization) proceeds will revert to the beneficiary, or if none is named, to the estate.  Because this limits potential payouts, it will provide a higher return than other plans. 

 

 

LIFE INCOME WITH PERIOD CERTAIN

The Life Income with Period Certain guarantees that annuity payments to a beneficiary will be made for a specific number of years, even if the annuitant dies before the end of this period.  Payments to the annuitant will continue as long as he or she lives.

 

LIFE INCOME WITH REFUND ANNUITY

The Life Income with Refund type of Annuity states that in event of the annuitant’s death, the company will pay an amount at least equal to the total dollars paid in as premiums.  The company will continue to pay the guaranteed amount of monthly income for as long as the annuitant lives.

 

There are two types of this annuity:

 

Cash Refund:  The Company agrees that if the annuitant dies, it will refund in cash the difference between the income that annuitant received and the amount that was paid in premiums plus interest earned.

 

Installment Refund:  The Company agrees to continue to make payments to the beneficiary until the total of the payments made to the annuitant and to the beneficiary equals the amount the owner paid for the annuity plus the interest earned.  The longer the payout is to continue after the annuitant’s death, the smaller will be the periodic payments.

 

 

TEMPORARY LIFE ANNUITY

The Temporary Life Annuity is a “combination” plan.  Annuity payments will be made until either (a) the end of a pre-determined number of years, or (b) until the death of the annuitant, whichever comes first.

JOINT AND SURVIVOR ANNUITIES

Under this arrangement, two people are insured, usually husband and wife.  Beginning on the date set in the contract, payments are paid to the annuitants.  Payments are guaranteed to continue to the surviving spouse upon the other spouse’s death.  Depending on the terms, the continuing payments will either be in the same amount as when both annuitants were alive, or be reduced. Obviously, the premiums are higher than those for life income annuities are since the likelihood of a long annuity payment period is greater when more than one life is covered.

 

Two types are commonly used. 

1.  Joint and 2/3 survivor, the surviving spouse receives two thirds of the income paid to the original annuitant.

           

2.  Joint and one-half survivor, surviving spouse receives half of the income.

COMPARISON OF ANNUITY vs CD NET RETURNS

 

Because of the tax treatment, the net return of an annuity will always exceed that of a Certificate of Deposit.  The following chart shows this difference quite dramatically.⁵

 

 

 

From this bar chart, it is obvious that greater growth is recognized by putting assets into annuities, instead of CD’s, and the longer the period of time that funds remain in annuities, the better performance.

TAX DEFERRAL IN THE SALES PROCESS

There is little doubt that tax deferral is an important selling point for annuities. A Gallup Organization study showed that tax deferral is one of several important reasons that individuals buy nonqualified annuities. 

 

74% 0f the owners of non-qualified annuity contracts believe that the government should give tax incentives to encourage people to save.  Those under age 64 are more likely than those who are older to believe that the government should give incentives to encourage people to safe -81% of those under age 64, compared to 69% if those older than age 64.

82% of the owners of non-qualified (NQ) annuities report that they have saved more money than they would have if the tax advantage of an annuity were not available.  88% report that they try not to withdraw any money from their annuity before they retire because they would have to pay tax on the money withdrawn – this percentage of people that are trying not to withdraw has decreased by 5% since 1999.⁶ 

TAX DEFERRAL VS LACK OF STEPPED-UP BASIS AT DEATH

One of the disadvantages of tax deferral on earnings is that deferred annuity income will be taxed at death.  However, if taxes can be deferred long enough – such as 5 years or more – that would usually offset the lack of step-up at death.  It should always be remembered that annuities are being used to ultimately provide retirement income, with payments taken periodically over a number of years.  This is discussed in more detail in Chapter Four.

WITHDRAWAL OPTIONS

Receiving the funds from an annuity, either fixed-rate or variable, is a double-edged sword.  The owner can always take out part or all of his/her money at any time.  However, any withdrawal may be subject to a penalty.  Note that withdrawal options may be different for those over age 65 as discussed later in this text.

 

Generally, an annuity will allow withdrawals of up to 10 percent per year without any penalty or other cost.  The “free” withdrawal is usually based on a percentage of the principal (not the current value).  If, for example, an annuity owner invests $25,000 into an annuity, and then later adds another $25,000, the owner may withdraw up to $5,000 every year, without penalty.  Even with investment growth, this would be the maximum that they could withdraw without penalty.  However, some annuities do allow a free withdrawal which is based upon the greater of (a) the current value, or (b) the principal contribution(s).

 

The contracts must be read carefully, as some companies will allow withdrawals of up to 15% per year, and others will allow free withdrawals of the growth at any time – or based upon the current value of the annuity (principal plus growth).

 

In respect to the withdrawals, recent statistics indicate that nearly three/fourths of those who invest in annuities, never take any money out of the annuities.  It should also be kept in mind that those restrictions on withdrawals eventually disappear.

 

Those restrictions on withdrawals, usually lasting about 5 to 7 years, do not apply to certain no-load annuities.  A “true” no-load annuity will usually allow withdrawals of any amount, at any time, without cost or penalty.

 

These restrictions do not mean that the owner cannot take out more than the specified amount – such as 10% - but if funds are taken out, a penalty will apply.  The amount of the penalty depends upon the type of annuity and the insurer.

 

 

ANNUITIZATION

 

Annuitization is the even distribution of both principal and interest, or growth of the annuity, over a specified period of time.  There is a distinct advantage to annuitization inasmuch as the disbursements are tax-favored.  Those situations where funds are sporadic, the tax-favorable status does not apply.

 

Annuitization is allowed under nearly all annuity contracts.  When the annuity is annuitized, the owner of the contract makes the decision as to how to receive the funds, i.e. what will be the mode of payment (monthly, semi-annually, annually, quarterly, etc.).  Variable contracts and fixed rate contracts may be annuitized. 

 

There is a disadvantage to annuitization.  Once the annuitization procedure has been established, it cannot be changed (except for a very few exceptions).  There can also be a disadvantage if a Variable Annuity is annuitized.  In those cases, the amount of the check will vary, depending upon the results of the sub-accounts selected and the amount of money allocated to these sub-accounts.  With a Variable Annuity, the investment “ups-or-downs” are risks of the person receiving the checks, which is usually the contract owner/annuitant, and is not that of the insurer.

 

Obviously, and as discussed in more detail later, the more “aggressively” the money is invested, the less predictable is the payout stream.  On the flip-side, if the annuity funds are invested in short-term bonds, utilities or money market sub-accounts, the more predictable the income will be from time to time.

 

Another possible disadvantage for annuitizing a fixed rate annuity is that the amount of each check depends upon the competitiveness of the insurer, what the current rates happen to be at that time, the duration of the withdrawals, and of course, the principal amount annuitized.

MORTALITY & ANNUITY TABLES

 

Those in the life insurance industry are familiar with mortality tables, at least in concept.  Basically a mortality table represents a record of the number of persons dying and those surviving at each age out of a composite of a large number of lives.  In other words, a mortality table is a chart that shows the rate of death at each age in terms of number of deaths per thousand.  It shows a hypothetical group of individuals beginning at a certain age and traces the history of the entire group year by year until all have died.⁷ 

 

The mortality tables based on life insurance experience are not suitable for use in the development of rates for annuities for several reasons:

1. Generally, annuities are purchased by persons in poor health.
2. Especially with single premium immediate annuities, the rates of mortality among annuitants are generally lower than those insured covered by life insurance policies.  Therefore, a life insurance table would overstate expected mortality rates.
3. While the continual improvement in mortality rates, even though offset occasionally by unanticipated developments (such as AIDs), creates a gradually increasing margin of safety for life insurance companies, it has just the reverse effect on annuities.

 

Therefore, an annuity table must show the lower rates of mortality that can be expected in the future instead of a table showing rates that have been experienced in the past.  Technically, these are called “Tables with Projection.” as opposed to “static” tables used for life insurance which did not provide for changes in rates depending upon the calendar year to which they were applied.

 

While life insurance has reaped the benefit of improving mortality, in annuity policies the improving mortality has led to smaller margins as the “postponement” of death means more annuity payments and annuity tables in use today usually contain projection factors that make allowance for future reductions in mortality rates.  The need for such calculations is particularly important in variable annuities because this portion of the annuity business is growing and there is no interest margin to help offset mortality losses that develop.

 

To further complicate this discussion, there are annuity tables that are used for different purposes.  For instance, the 1949 Annuity Table was developed to reflect steady improvement in mortality; the 1955 Annuity Table was developed to help determine the proper rates for annual-premium deferred annuities and live income settlement options.  In 1971 the Group Annuity table was developed for the (at that time) time field of group annuities.  Presently, the 2000 Annuity Basic Mortality Table has been endorsed by the Society of Actuaries to be used for individual annuities written in the U.S. but it is an extension of the 1983 Individual Annuity Mortality Table.  

 

For educational and information purposes, the 1983 Table for ages 61 to age 85  is reproduced below.  The complete tables start at age 5 with 10,000,000 lives at the beginning of the year and run to 115 years when it is assumed that everyone has passed on.⁹ 

 

Age (x) at Beginning of Year	Number Living at Beginning of Year (lx)	Number Dying during Year (dx)	Yearly Probability of Dying (qx)	Yearly Probability of Surviving (px)
61	8,938,628	80,296	0.008983	0.991017
62	8,858,332	86,280	0.009740	0.990260
63	8,772,052	93,247	0.010630	0.989370
64	8,678,805	101,230	0.011664	0.988336
65	8,577,575	110,230	0.012851	0.987149
66	8,467,345	120,228	0.014199	0.985801
67	8,347,117	131,192	0.015717	0.984283
68	8,215,925	143,072	0.017414	0.982586
69	8,072,853	155,774	0.019296	0.980704
70	7,917,079	169,196	0.021371	0.978629
71	7,747,883	183,214	0.023647	0.976353
72	7,564,669	197,672	0.026131	0.973869
73	7,366,997	212,427	0.028835	0.971165
74	7,154,570	227,472	0.031794	0.968206
75	6,927,098	242,767	0.035046	0.964954
76	6,684,331	258,222	0.038631	0.961369
77	6,426,109	273,669	0.042587	0.957413
78	6,152,440	288,863	0.046951	0.953049
79	5,863,577	303,469	0.051755	0.948245
80	5,560,108	317,071	0.057026	0.942974
81	5,243,037	329,216	0.062791	0.937209
82	4,913,821	339,452	0.069081	0.930919
83	4,574,369	347,231	0.075908	0.924092
84	4,227,138	351,825	0.083230	0.916770
85	3,875,313	352,603	0.090987	0.909013

 

APPLICATION OF MORTALITY TABLES IN RATE MAKING

 

Actuarial computations and calculations as to how rates (premiums) are determined in detail are outside the scope of this discussion.  However, the basic concept of how annuity premiums are determined should be known by those who represent annuity insurers – even an auto salesman needs to have some understanding what happens within the block of steel in the front part of the car. 

 

The mortality tables show the probability of a person living or dying at certain ages at certain periods of time.  Using this table (above), in order to determine what the gross premiums for a life insurance policy payable in 5 years for a man age 61, there are 8,938,628 men living at age 68, and 80,296 dying before the end of that year.  Therefore, the probability of death at that age is 80296 divided by 8938628 or .008983 for the first year.  To determine how many are “left standing” 5 years hence, this arithmetic is repeated for the next five years by adding the number of persons dying each year (471283) and dividing by 8938628 which give the probability factor of .0527243.¹⁰   

 

For an annuity, the process is just reversed inasmuch as probabilities of survival or chance of living for at least one year following issue age will be a fraction, the denominator of which is the number living at age 61 and the numerator of which is the number that have lived one year following the specified age (i.e., to age 62).  This would be 8938628 divided by 8858332, thus probability of surviving would be 1.0090644. 

 

To an actuary, this is just a start of premium calculation as the interest that the company will receive on premiums received over the period of the policy/annuity, and expenses that will occur in both issue and maintenance in addition to the survival probability must be calculated.  In addition, there must be some profit for the company calculated plus a margin for contingencies.  All of these are factored in with the age and sex of the annuitant.  Now you see why actuaries get the “big bucks.”

 

ANNUITY RESERVES

One of the primary functions of actuaries is the calculation of “reserves.”  The best way to explain this complicated subject is to use the method used for Deferred Annuities.

 

DEFERRED ANNUITY RESERVES

Deferred annuities are usually paid for by flexible, periodic premiums, or sometimes by fixed and periodic premiums.  Even though the premiums may be flexible, the contract holder may choose to pay a level amount into the annuity so as to build to a larger sum at annuitization and/or retirement.  Theoretically, premiums may continue through the entire period of deferment.  The level annual premium is paid only while the insured is still alive.

 

If, for example, the deferred annuity issued at age 40 starts the payment of $100 a month at age 70, and if the net single premium (the amount needed to deposit immediately to create the payment at age 70) for this is $239.36, the annual premium on this policy may be paid until one year prior to the annuitization of the payment of the benefits (in this situation, the contract holder would be age 69).  Therefore, the series of annual payments is a temporary annuity due for a term of 30 years (age 40 to age 69 inclusive).  The amount of this net annual premium would be found by dividing the net single premium by the present value of an annuity due of “1” computed for the 30 year period.

 

The present value (as calculated by the actuaries from existing tables) of the 30 year annuity just happens to be 16.141 (actually, it is 15.141 plus 1 – if that helps) or to put it in another way, the present expected value or an annual level premium of “1” paid over the same term as the premiums on the deferred annuity.  This figure, divided into the net single premium for the annuity, gives a net annual level premium of

                                          $239.36

                                            16.141           which equals  $14.83

 

Now that we know how a net annual premium is created, obviously there has to be funds held by the insurance company to pay for any such obligations.  Therefore, there are “reserves.¹¹”

 

RESERVING

The reserves of an insurance company basically reflects its obligations to its customers.  Policy reserves are liabilities that represent in respect to business in-force, the amount that, with future premiums and interest earned, is expected to be needed to pay future benefits.   Another explanation is simply that reserves are the present value of future benefits.  Reserve calculations require the use of mortality tables and an interest rate.  If an insurer underestimates its policy reserves, or fails to maintain sufficient assets to back its reserves, it may find itself in the untenable situation of not being able to pay claims. 

 

Incidentally, there are other reserves, such as Reserves for Substandard Policies; Reserves for Special Benefits, Reserves for Premiums Paid in Advance, Reserves for Claims Not Reported, etc., but the Policy Reserves are the most important – far and away!

RESERVES FOR INDIVIDUAL DEFERRED ANNUITIES

As stated, there are 3 basic forms of annuities – flexible or fixed-premium deferred annuities, single-premium deferred annuities, and single-premium immediate annuities.  The policy reserve for the majority of the annuities is equal to the present value of future benefits  because most annuities in today’s market are either flexible-premium deferred annuities (FPDAs) or single-premium immediate annuities. 

 

For the FPDAs, insurance companies cannot know for sure what premiums the contract holder may make in the future.  Therefore, the policy reserve must be calculated on the premise that the contract owner will pay no future premiums.  This, then, makes the policy reserve equal to the present value of future benefits for both single-premium and flexible-premium policies.

 

Then, when an annuity starts paying benefits, the reserves are based on a (legally recognized) mortality table and interest rate according to the annuitant’s attained age and monthly income – taking into consideration any minimum benefit guarantees.  The assumed mortality is calculated conservatively – meaning lower mortality rates.

 

FPDAs are simply policies where the owner pays annual premiums during the period of accumulation, until the owner starts receiving benefits in the form of income.  When the benefits start, the annuitant receives the monthly income based on the cash value of the policy at that time and an annuity factor for the attained age of the annuitant.

 

Contracts in which there are no further payments are reserved as net single premiums (the present value of future benefits), including single-premium life and endowment contracts, immediate life annuities, and paid up life and endowment contracts and supplementary contracts used in lieu of lump-sum payments.

 

REGULATIONS REGARDING FUNDING AGREEMENTS

When an insurer accepts funds to provide for an accumulation of funds for the purpose of making payments in future dates in “amounts that are not based on mortality or morbidity contingencies,^12A” this is called a “funding agreement.”  The regulations state that “no amounts shall be guaranteed or credited under any funding agreement except upon reasonable assumptions as to investment income and expenses and on a basis equitable to all holder of funding agreements of a given class.

 

THE EFFECT OF LOW INTEREST RATES ON RESERVING

The impact of reserves of a change in the interest assumption can be understood as if the rate of interest assumed in the reserve calculation is decreased, then it follows that there will be an increase in reserves.  The rule, simply put, is that the smaller anticipated earnings must be offset by a larger reserve at any point in time.  Remember, in calculating the present value of $X, the higher the interest rate assumed, the lower the present value of $X will be, all things taken into consideration.

 

What does this have to do with anything?  If the interest rate – which undoubtedly will go no lower than it was during the first part of 2004 (no such thing as a negative interest rate) is what the insurer is getting on its investments – which consist primarily of the premiums received – then at time of claim since it did not make as much money on investing of the premiums as assumed in the premium and reserve calculations, the insurer would not be able to meet its financial projections, etc.  Fortunately, interest assumptions on new business drops as the interest the company receives on its investments drops.  Unfortunately, the company still has to pay the income promised under the policy, regardless of what their interest income had been during the accumulation period.

 

This simply means that an annuitant that took out a deferred annuity would still collect – as an example - $100 for every annual payment (premium) of $14 and change which was promised when the annuity was purchased some time back when interest rates were high.  For another new annuitant, the premium for $100 for comparative coverage might be as high as $18.  The offset, of course, is that the annuitant cannot put the same money into another investment and receive a much higher interest than what is received by the insurance company, who has the advantage of large portfolios professionally managed and therefore can get higher interest than Joe Lunchbucket.

 

Interestingly, the nation’s life and health insurers had a 310.8% jump in net income last year, earning $30 billion compared to $7.3 billion in 2002.¹²  The rebound in the equity market was responsible for the increase in earnings as insurance companies saw improvement on the sale of invested assets.  Insurers had a $4.6 billion capital loss in 2003, compared to a $15.5 billion capital loss just a year earlier.  Capital and surplus of the insurers had its largest increase in profits since 1997. 

 

“The equity markets were much kinder to the industry in 2003, and we expect to see positive gains as 2004 progresses.  Insurers didn’t need to dip into capital as much to absorb the higher losses and maintain reserves.”¹³  So, things are looking up!

ANNUITY NONFORFEITURE VALUES

Nonforfeiture values are understood by most as a life insurance policy function but it also applies in slightly different ways for an annuity.  Basically, in life insurance it is a provision that the insured may receive the equity in some form, even if the policy is cancelled.  For annuities, it is described as the vested benefit usually to a retirement plan participant and is enforceable against the plan.

 

It is of importance as the National Association of Insurance Commissioners (NAIC) promulgates “Model” legislation for the regulation of the insurance industry in the various states, and that is usually adopted by most, if not all, of the state insurance departments.  Changes to the annuity nonforfeiture law were made in 2002 to address the reduction in interest rates in and after 2002, and a standard nonforfeiture law for deferred annuities was proposed by the NAIC.  The change, which is temporary, would be from 3 percent to 1.5 percent to the minimum interest rate in the annuity nonforfeiture law, and which would be effective for 2 to 3 years (by state determination).  When such provision “sunsets,” which would be sometime between July 2004 and July 2005, the minimum rate will be returned to 3 percent.  (This may have happened at the time of the writing of this text, so it may have already expired in some states where it was enacted.)

 

The NAIC Model Standard Nonforfeiture Law for Individual Deferred Annuities proposes 6 principal changes¹⁴:

1. (For deferred annuities) a minimum interest rate indexed to the five-year Constant Maturity Treasurer (CMT) rate, minus 1.25 percent.  For equity-indexed plans, the minimum rate could be reduced by an additional 1 percent, but subject to guaranteed equity-indexed benefits of at least as great as the rate reduction.
2. The minimum interest rate will be the lesser of 3 percent or the rate determined by the 5-year CMT index, but it may never be less than 1 percent.
3. The interest rate can be redetermined at specific contract dates; the reset rate can be as of a single date or averaged over the most recent 15 months.
4. An annual charge of $50 can be recognized.  No collection charge is allowed.
5. The net considerations are 87.5% for all products.
6. Premium tax can be reflected in the nonforfeiture law.

 

Every annuity issued must contain certain provisions¹⁵ :

1. When annuity premiums cease or when the annuity owner requests, the insurer must provide a paid-up annuity benefit.
2. If the annuity provides for lump-sum settlement when it matures – or at any other time – a cash surrender benefit in lieu of a  paid-up annuity benefit.  Payment may be deferred for no longer than 6 months with the permission of the Insurance Department.
3. The annuity must contain a statement of the mortality table and interest rates that are used in calculating minimum paid-up annuity benefits, cash surrender, or death benefits that are available under the annuity and any other information necessary to calculate these benefits.
4. The annuity must state that these benefits are equal to or more than the minimum benefits required by the state in which the annuity is delivered. 

 

Regardless of these requirements, any deferred annuity may provide that if there have been no consideration received for a period of two years, and the present value of the annuity is less than $20 monthly, the present value of the annuity is determined according to the Code, and may be paid in cash.

 

For annuities issued before 1/1/04 and prior to 1/1/06, the California Insurance Code¹⁶ provides for minimum nonforfeiture values.  For flexible contracts, the amount is specified by formula which assigns an interest rate of 3% for accumulations less withdrawals, indebtedness to the insurer plus additional amounts assigned by the insurer.  The percentage of net consideration must be 65% for the first year and 87.5% for later years.

 

For fixed premium contracts, the portion of the net consideration is the same as for flexible contracts (65% and 87.5%).  For single premium contracts, the minimum nonforfeiture amounts shall be defined as those with flexible considerations except the minimum nonforfeiture amount shall be equal to 90% ad the contract charge shall be $75.

 

For contracts issued on and after 1/1/06¹⁷, the determination of the nonforfeiture values resembles the calculations shown above, but with annual contract charge of $50 (instead of $30) and the interest rate used in determining the nonforfeiture values will be 3% per annum.  If the interest rate is offset, then the code requires a Constant Maturity Treasury Rate to be used for each redetermination date.

 

For equity indexed plans, provisions for determining the nonforfeiture values is stated in the Code.  Each revaluation must show that each redetermination the additional reduction shall not exceed the market value of the benefit.

 

For a paid-up annuity¹⁸, the benefit available under the annuity shall be the present value on annuitization which must be at least equal to minimum nonforfeiture on that date.   

 

For a paid-up annuity which provides cash surrender benefits, the Code¹⁹ provides a (145 word) sentence outlining the cash surrender benefits available.  Simply (very simply) put, the present value of future benefits less payments made on the annuity, would be the non-forfeiture amount, but the cash surrender benefit may not be less than the minimum nonforfeiture amount at that time.  The death benefit must be at least equal to the cash surrender benefit.

 

For annuities that do not provide cash surrender values²⁰, the nonforfeiture amount shall not be less than the present value of the maturity value of the paid up benefit, adjusted by payments and obligations. 

 

Not all annuities provide for cash surrender benefits or death benefits, and those plans must so state in a “prominent” place on the contact.²¹

 

If a contract provides – by rider or otherwise - annuity benefits and life insurance benefits or a return of premium or gross considerations with interest, the minimum nonforfeiture values of the annuity portion will be calculated individually and then combined.²²

 

THE POSITION OF THE SEC ON FIXED ANNUITIES

For those who first approach fixed annuities on a marketing basis, it is obvious that the fixed annuity has been exempted from Securities and Exchange Commission regulations regarding securities.  Such exemption was first granted in 1986 under Rule 151 and such annuities are exempt (Under Section 3(a)(8)).  Rule 151 is a “safe harbor” act – which means that annuities that annuities falling under the rule are entitled to rely upon the exemption.  This does not mean however, that an annuity that does not fall within the scope of the rule may not still be excluded according to the Section 3(a)(8) exemption.²³

 

For an annuity to be exempt under Rule 151, there are two basic tests:

1. The insurer must assume the investment risk under the contract as defined in the rule, and
2. The contract must not be marketed primarily as an investment.

 

These tests will be discussed elsewhere in this text in more detail.

 

There are four “prongs” to the investment risk test, and each must be satisfied.

 

1. The value of the contract must not vary according to the investment experience of a separate account.  (This is discussed later as a major reason the Equity Indexed Annuity is exempt);
2. The contract must guarantee the principal amount of premiums and all interest credited to it for its entire duration, less any deduction for sales, administrative or other expenses or charges;
3. The contract must (again for its full duration) guarantee that the net premiums and the interest credited to it thereto, will be credited with a specified rate of interest at least equal to the minimum rate required to be credited by the relevant nonforfeiture law in the jurisdiction in which the contract is issued; and
4. The insurer must guarantee that the rate of any discretionary excess interest to be credited to the contract will not be modified more frequently than once a year.

 

There is also a marketing test, but it is far from explicit – however the SEC in the release of Rule 151 indicated some pertinent points that they would take into consideration.  Basically, they require that there be

1. no undue emphasis based on current rates of interest;
2. the products should be presented as a relatively safe and secure retirement savings vehicle;  the insurance and other retirement features (such as payout options, death benefits, etc.) should enjoy at least equal emphasis with the current interest rate feature.

 

There are other, highly technical, considerations that the SEC will take into consideration in determining whether a particular product falls within the exemption.

STATE SECURITIES REGULATIONS OF ANNUITY CONTRACTS

The question may arise whether state securities regulations apply to annuity contracts, and if so, do they duplicate SEC regulations.  The National Securities Markets Improvement Act (NSMIA) of 1996 preempted certain duplicative state securities regulations of registered variable annuities, and other annuities exempt under federal securities laws.  The NSMIA preempts state securities review and registration of all securities subject to SEC registration, which includes Variable Annuity contracts, underlying mutual funds, and securities exempt from registration because of federal regulations.

 

However, a state may require a “notice” filing of securities that are sold in that state, which includes documents filed with the SEC, the sales of the securities, and consents to service of process.  They may continue to collect fees for certain securities.  And, of course, states continue to have the authority to regulate annuities under state insurance laws.

 

 

 

1.  An annuity is like life insurance in many ways, excluding

      A.  premiums may be paid by several modes, other than just monthly.

      B.  the fact that annuities are usually sold by life insurance companies.

      C.  both require physical examinations to qualify.

      D.  the fact that both can be set up to provide coverage for the life of the insured.

                                                                                               

 

2.  The owner of an annuity may not be

      A.  an individual.

      B.  a trust.

      C.  a corporation.

      D.  a minor.

 

3.  The person that purchases an annuity is

      A.  the owner.

      B.  the beneficiary.

      C.  the annuitant.

      D.  a non-legal entity.

 

4.  An annuitant can benefit from an annuity only

      A.  if someone else purchases the annuity.

      B.  if the annuitant is a corporation.

      C.  when it annuitizes.

      D.  when the contract owner dies.

 

5.  The beneficiary of an annuity has “no status” until

      A.  the death of the beneficiary.

      B.  a loan has been made on the annuity.

      C.  the death of the annuitant.

      D.  the beneficiary becomes age 21.

 

6.  If the annuitant reaches a certain age, dies, or becomes disabled, certain provisions of an annuity would govern, therefore these annuities are considered as

      A.  owner-driven.

      B.  insurer-driven.

      C.  beneficiary driven.

      D.  annuitant driven.

 

7.  With a deferred annuity, if death occurs before the annuitization period stated in the contract,

      A.  the contract becomes null and void.

      B.  the annuitization period would then start and the payments would be sent to the state.

      C.  the cash value paid to the beneficiary would equal the amount of premiums paid in.

      D.  the annuity is automatically converted to a whole life insurance policy.

 

8.  When an annuity specifies the number of benefits payment of a set amount, it is

      A.  an equity indexed annuity.

      B.  an annuity certain.

      C.  a Variable Annuity.

      D.  an immediate annuity.

 

9.  The maximum income per dollar of outlay is provided by

      A.  the straight life annuity.

      B.  life income with period certain annuity.

      C.  life income with refund annuity.

      D.  temporary life annuity.

 

10.  The even distribution of both principal and interest, or growth of the annuity, over a specified period of time is

      A.  the death benefit.

      B.  annuitization.

      C.  collateralization.

      D.  escrowing.

 

ANSWERS TO STUDY QUESTIONS

1C     2D     3A     4C     5C     6D     7C     8B     9A     10B