Introduction to Variable Annuities To begin the course, click on the forward arrow in the bottom navigation bar or click the next topic in the left menu

Introduction to Variable

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Introduction to Variable Annuities

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Key Terms Glossary

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Lesson 1Overview of Variable Annuities


Lesson 1 Objectives

After completing this lesson you will be able:

1. To explain the basic concept of annuities.

2. To discuss the basics in the operation and benefits of fixed and variable annuities.

3. To discuss basic funding, investments and distribution of accumulated benefits in a variable annuity.

4. To discuss the use of sub-accounts within the variable annuity for personalized asset management.

5. To list the different applications of variable annuities as funding vehicles.

Lesson 1: Overview of Variable Annuities

The Annuity Concept

In its most basic form, an annuity is a contract with an insurance company. In exchange for the investment of cash premiums into the contract (“accumulation phase”), the insurance company will provide the contract holder or his or her designated beneficiary (“annuitant”) with a guaranteed lifetime income (“annuitization phase”).

The basic principle of the annuity is the systematic liquidation of accumulated assets to provide the income guaranteed under the contract. The systematic liquidation usually takes place in the form of monthly payments.

While contributions into an annuity may or may not be tax-deferred (this will be discussed in more detail later), the earnings on contributions during the accumulation phase compound on a tax-deferred basis. That is, no income tax obligation will generally attach to the earnings on investments in the contract until they are actually disbursed.


Question 1-1

PROPERTIES

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The contract holder of an annuity controls the amount and timing of his or her contribution into the contract. The contract holder also controls how and when benefit payments under the contract will begin.

The options for distribution of assets under a contract (referred to as “settlement options”) are traditionally:

· Lifetime (“annuitizing”)

· Period and/or amount certain

· Partial and lump sum disbursements

The Annuity Concept


The contract holder also selects:

· The annuitant (if other than himself or herself)

· The beneficiaries

· The contingent beneficiaries

The contract holder may change these selections at any time during the accumulation phase of the contract.

The Annuity Concept


Annuitizing a Contract

Annuitizing a contract means that at the beginning of the distribution phase, the annuitant of the contract has opted to receive a series of guaranteed payments from the annuity until death. Annuitizing guarantees the recipient of the payments that he or she will not outlive his or her financial means.

When the annuitizing option is elected, the insurance company transfers the assets under the contract into its general accounts from where the guaranteed payments will be drawn. The transfer of assets into the insurance company general accounts is treated as a purchase of the guaranteed benefits.


This means that the contract owner no longer has the option to access the principal in the contract through distribution or loan. It also means that, upon the death of the annuitant, the insurance company is not obligated to provide a death benefit under the contract to the designated beneficiaries.

Annuitizing a Contract


Question 1-2

PROPERTIES


Death Benefit Aspect of an Annuity

The death benefit of an annuity provides for the passing of the value of the annuity directly to the designated beneficiaries upon the death of the owner.

This death benefit is paid only if the owner has died during the accumulation phase of the contract or if the owner elected to not annuitize benefit payments under the contract and died prior to the payout of the entire interest accumulated under the contract. Because these assets are directly passed, they do not go through the probate process.


Two Basic Forms

The annuity comes in two basic forms:

· Fixed annuity

· Variable annuity

The fixed annuity provides payments at a pre-established amount that is guaranteed for the life of the contract. Fixed annuity investments function very much like a bank certificate of deposit.

Because the payments are guaranteed in a fixed annuity, the insurance company assumes all of the risk on the underlying investments. Consequently, insurance companies tend to invest the assets underwriting fixed annuities in stable vehicles such as municipal bonds and treasury bills.

This conservative asset management allows the insurance company to guarantee the return under the fixed annuity contract.


Variable Annuity

The variable annuity, in contrast, offers no guarantee on the amount of benefit payments. Under a variable annuity, payments are based upon the performance of the underlying investments.

Variable annuity investments function very much like mutual fund investments. The investment risk under a variable annuity is shifted to the contract holder.


Variable annuities provide investors with a series of investment alternatives under the contract that cover the risk/reward spectrum. Most variable annuities will offer stable and secure selections such as bond and money market funds as well as high risk/high return investment options such as international equity and small-cap stock funds.

By being able to direct the investment of assets accumulated under the variable annuity contract among the various alternatives offered under the contract, the annuitant can tailor the management of the assets to meet his or her particular risk tolerance.

Variable Annuity


Question 1-3

PROPERTIES


Sub-Accounts

After the contract holder has selected an insurance company to provide the variable annuity contract, he or she must select where to invest the contributions placed into it. The insurance company will have selected a series of investments to be offered through the contract. These investment alternatives are known as sub-accounts.

Each sub-account will have a distinct investment objective. Variable annuity contracts usually offer a sufficient range of sub-accounts to cover the entire risk/reward spectrum of conservative investments designed to guarantee the safety of the principal investment, all the way to high risk/high yield aggressive growth funds and everything in between.


The typical variable annuity will have an accumulation account (also referred to as the “separate account”) that serves as a master investment account.

All contributions from the contract holder are initially placed in the accumulation account until the contract holder determines the allocation of the contributions among the various sub-accounts.

Most variable annuities provide a basic sub-account referred to as the “guaranteed account” (or, the “fixed account”). The guaranteed account functions like a fixed annuity. Assets placed in the guaranteed account are guaranteed a rate of interest return by the insurance company regardless of the insurance company’s actual investment performance on the assets invested in the guaranteed account.

Sub-Accounts


The mix of funds in the remaining sub-accounts represent investments in stocks, bonds and cash equivalents. Some examples of the type of sub-accounts usually offered include: money markets; government securities, utility funds, fixed income, corporate equity like (small capitalization, medium capitalization and large capitalization), market index funds (such as the S&P 500, Russell 2000, etc.), growth funds, aggressive growth funds and international equity funds.

By selecting among the various sub-accounts and their investment objectives, the contract holder is able to personalize the investments in the variable annuity to best meet his or her objectives.

Sub-Accounts


Question 1-4

PROPERTIES


Uses for Annuities

In addition to the basic concept of providing the annuitant with a guaranteed income for life, there are various reasons for investing in variable annuities.

Retirement Planning.

Annuities can be ideal investment vehicles for supplementing retirement assets accumulated through employer-sponsored retirement plans and/or social security.


Classification

The term “nonqualified” refers to the classification assigned annuities under the provisions of the Internal Revenue Code (IRC).

A “qualified” annuity is one offered through a retirement plan that has satisfied the stringent elements for tax-deferred status under Code sections 401(a) (for employer-sponsored plans) and 408 and 408A (for Individual Retirement Accounts, or IRAs).

The term “nonqualified” in no way is a reflection on the quality of the annuity or on the stability of the insurance company offering the contract.

In other words, “nonqualified” simply means the annuity is not being offered through an employee benefit plan and, therefore, may be purchased by any individual. Qualified annuities will be discussed in much greater detail in Lesson 4 – Qualified Annuities.


Question 1-5

PROPERTIES

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Small Business Owners

For many small business owners, the nonqualified annuity is the best alternative available for accumulating retirement assets. This is because many small business owners do not have the expendable capital to invest in an IRA when they are younger and struggling to make the business profitable.

As they grow older and, hopefully, more successful, they may shy away from adopting a qualified retirement plan because of the additional expenses of plan design, administration and the provision of benefits to all employees.

The nonqualified variable annuity provides this business owner with the ability to defer earnings like an IRA would, without the annual contribution limit an IRA has. This also allows for a rapid build-up of principal.


Earnings on Investments

As noted earlier, earnings on investments under a variable annuity accumulate on a tax-deferred basis. Tax-deferment means that all capital gains and dividends are automatically reinvested under the contract without the burden of current federal, state, or local taxation. This offers a triple compounding effect on the accumulation of wealth under the variable annuity.

The triple compounding, therefore, means that the contract owner earns capital gains and interest on:

1. Principal invested in the contract

2. Earnings on the principal investments

3. The money the contract owner would otherwise have to take out of the contract and pay in the form of federal, state and local taxes


Charitable Planning

There are occasions when variable annuity contract holders would like to make a gift of the assets accumulated under the contract, or even the contract itself.

Making a gift of the assets under a variable annuity contract, or making a gift of the contract itself, involves various income tax consequences to both the party making the gift and the party receiving the gift.

These taxation issues are discussed in greater detail under Lesson 5 – Taxation Issues.


In addition to the traditional charitable planning, there are other situations that could be considered charitable planning. Such instances would include grandparents who funded a variable annuity to provide for the college expenses of a grandchild, but it turns out that the grandchild does not need the money for college, either because he will not attend college, or because he earned a scholarship. In this case, the grandparents may want to make a gift of the annuity to charity.

Others may find that they have acquired sufficient retirement income from other investments and desire to make a gift of their variable annuity for estate planning reasons.

Charitable Planning


Question 1-6

PROPERTIES


Another type of charitable planning involves the gifting of cash or property by an individual to a charitable institution such as a church or university.

Under this type of charitable planning, the individual making a gift to the charitable organization receives, in exchange for the gift, an annuity from the charity for the remainder of his or her life.

A charitable annuity does not involve a traditional annuity contract. Rather, it is a direct agreement made between the gift giver and the charitable institution that is backed by the charity’s assets and good name.

Charitable Annuity


College Planning

With the four-year costs of sending a child to college going as high as $120,000 for private institutions and $30,000 for state schools, it is easy to see the advantage of saving for these expenses through the tax-deferred growth of assets in a variable annuity. However, as with most other annuity payout situations, distributing the money from a variable annuity to pay for the education costs of children involve certain income tax consequences.

If the parent taking the distribution is under age 59-1/2, there is a 10% penalty on the amount of the distribution that must be paid on top of any income taxes that accrue. This can virtually wipeout the tax deferred growth advantages.


The pre-age 59-1/2 penalty can be avoided if the parent will be that age, or older, when the child enters college. Another method for avoiding the 10% penalty would be for the child’s grandparents to establish the variable annuity contract so that they will be older than 59-1/2 when they take the distributions to pay for their grandchild’s college expenses.

College Planning


Business Planning

In addition to the retirement savings advantages variable annuities provide the small business owner, there are other reasons for the business owner to invest in variable annuities.

Nonqualified deferred compensation plans can be invested in variable annuity contracts. Nonqualified deferred compensation arrangements are retirement programs for owners and key executives.

Because they do not satisfy the stringent coverage and non-discrimination rules required of qualified retirement plans, they are not eligible for tax-deferred status on compensation contributed or on income from the investments under the Internal Revenue Code.


Question 1-7

PROPERTIES


Business Planning

In fact, prior to the Tax Reform Act of 1986, variable annuities were popular vehicles for funding deferred compensation plans. Unfortunately, the Tax Reform Act of 1986 contained a new rule that says any earnings on contributions made after February 28, 1986 to a deferred annuity contract that is owned by a corporation or other non-natural entity are taxable in the year they are earned.

This loss of tax deferral status for corporate owned annuities is known as the “non-natural person rule”. This rule has made the use of variable annuities for the funding of deferred compensation plans much less attractive.


Variable annuities can also be used to assist the small business owner in making the transition to retirement.

Many small business owners continue to work for their business after selling on a contingency basis. This allows for a smooth transition to the new ownership and encourages long-time clients to stay with the business and develop familiarity with the new owners while the former owner is still actively involved.

The owner can take the proceeds from the sale of the business and use them to fund the initial investment into a variable annuity. Subsequent salary or consulting fees paid during the contingency period can also be used to make additional investments into the variable annuity.

Business Planning


Nonqualified bonus plans may also consider the advantages of investing in variable annuities.

Under a typical bonus plan, the employer selects certain top-level employees to receive a salary increase or a bonus. The additional funds paid to the employee are placed into the bonus plan. The payments are deductible to the employer and must be included in income by the employee.

Once the funds are in the bonus plan, the employee uses them to pay the premiums on a life insurance policy that he or she owns.

However, if the employee is uninsurable due to pre-existing health conditions, the employee can invest the funds into a variable annuity.

Business Planning


Lesson 1 Quiz

PROPERTIES


Lesson 1 Read More Supplement

If you will be taking the mastery exam at the end of the course or wish to earn CE credit, it is necessary for you to review the information in the supplemental section. Information contained only in this section will be included on the exam. Review information by clicking here.


https://clients.pinpointglobal.com/NUCO/upload/VA-RM-1.pdf

Lesson 2The Variable Annuity Contract


Lesson 2 Objectives

After completing this lesson, you will be able to:

1. Explain the structure of the variable annuity contract

2. Discuss how variable annuities are traditionally funded through the payment of premiums

3. Explain the traditional charges and fees associated with variable annuity contracts such as assumed rates of interest, loan fees and surrender charges

4. List the various settlement options traditionally available through variable annuity contracts

Lesson 2: The Variable Annuity Contract

The Contract

In its basic form, the variable annuity contract is best described as a formal written agreement between an insurance company and an individual or a group. This sets forth the obligation of the insurance company to provide for the systematic liquidation of assets invested and accumulated by the individual or group for the provision of income to the individual or group identified within the formal agreement.

Although not all annuity contracts offered by all insurance companies are identical, there are certain provisions that must be provided in every variable annuity contract issued. Some provisions are evident in all variable annuities because they are essential to the structure of the arrangement. Others are contained in all contracts because they are statutorily mandated.

We will discuss provisions common to most variable annuity contracts.


Question 2-1

PROPERTIES


Eligibility

All variable annuity contracts must detail the provisions that make an individual or a group eligible to participate in the contract. Individuals and groups can participate in qualified and nonqualified contracts (as discussed in Lesson I).

The age restriction most companies impose in the contract is of specific importance to the eligibility to participate in a variable annuity contract. The industry average for the maximum eligibility age to participate in a variable annuity contract is 80 to 90 years. Senior citizens looking to invest in a variable annuity contract will need to carefully review the eligibility provisions of any contract under consideration to make certain they may enter into the agreement, and should make sure it is a suitable investment for their unique investment.


With an industry average on the maximum eligibility age well beyond the age most individuals retire, it is easy to see why a variable annuity provides senior citizens an excellent opportunity to continue accumulating retirement assets on a tax deferred basis well beyond their normal retirement age.

Eligibility


Free-Look Period

Variable annuity contracts are required, by state statute, to provide investors with a “free-look period.” The free-look period varies from state to state.

In general, it allows the purchaser of a variable annuity contract a period of 10 to 20 days after the initial purchase to return the contract, for any reason, and have it cancelled.

However, most contracts do provide for the imposition of certain fees, mortality charges and investment losses against the purchaser.


Interest Rates – Guaranteed Account

Most variable annuities offer an investment option into a guaranteed account (they are also commonly referred to as “fixed,” “general” or “deposit” accounts).

This account functions much like a fixed annuity in that it provides the investor with a guaranteed rate of return on assets placed in it. The minimum interest guaranteed is usually in the three to four percent range. Guarantees are subject to the claims paying ability of the issuing company, and rates will vary.

Traditionally, the rate of return is guaranteed for one, three or five years. However, it is not uncommon for variable annuities to offer guarantees from thirty days up to seven years.

Once the initial period has run, renewal rates are guaranteed at then applicable market rates. The renewal rates can also run for multi-year periods, but they are traditionally set at one-year.


Interest Rates – Variable Accounts

Most guaranteed accounts in variable annuities provide a limit on the overall percentage of assets in the contract that can be allocated to the guaranteed account. Typically, no more than 10% of assets invested in the variable annuity contract may be allocated to the guaranteed account.

There is no performance guarantee on the rates of return in the other variable annuity sub-accounts. The contract owner assumes the entire investment risk for assets placed in these accounts.

When the market becomes so volatile that the contract owner becomes concerned with the safety of his or her principal, the variable annuity always offers the benefit and comfort of the guaranteed account as an investment option.


Question 2-2

PROPERTIES


Premium Payments

Typically, insurance companies have minimum premium requirements for initial and subsequent premium payments. Initial premium payments may be a relatively low amount such as $50 or $100. Some companies will require relatively high initial premium submissions. These can be as high as $25,000.

The insurance company must agree to accept the initial premium payment in order to put the variable annuity contract into effect. This is also referred to as being “in force.”

An insurance company is very careful to make certain that compliance and suitability requirements have been met before it will accept an initial premium. This premium must be applied to the accounts specified by the contract owner within five days, unless the owner has requested that it be held longer.


Premium Payments

Subsequent premiums can be less than the initial premium. The usual methods of paying subsequent premiums are annual, semi-annual, quarterly and monthly remissions.

Since most variable annuities have flexible premiums, meaning that they may vary at the will of the contract owner within the minimum and maximum premium limits, the premium notices serve more on the order of reminder notices.

When premiums have not been paid for some period of time and the account values are minimal, in general, insurance companies reserve the right, to terminate the contract and return the values to the owner. Of course, contracts with high minimal initial premiums do not encounter this minimal account values situation unless there have been large withdrawals.


Issue and Maturity Ages

Variable annuities are issued to young and middle-aged persons, as well as senior citizens up to ages 80, 85, or even 90.

Immediate annuities, which begin payout of benefits within one year of purchase, can be issued to nearly any age, providing that suitability requirements of the annuitant are met.


Question 2-3

PROPERTIES


Contract Payout Dates

Contract payout dates are one of the distinguishing characteristics of an insurance and annuity product (as opposed to other securities such as mutual funds). Most variable annuities have a maturity date, which is the contract anniversary date upon which the annuitant reaches a certain age.

Variable annuities used in IRAs and Tax-Sheltered Annuities (also referred to as “403(b) plans”) must begin distributions the year after the year that the annuitant attains age 70-1/2 per IRS regulations for qualified plans.

Nonqualified annuities usually have maturity dates much higher than age 70-1/2 in fact some can go as high as 90 years of age.


Bailout Provisions and Rates

Some annuities provide that, if renewal interest is ever credited below a certain specified rate (the “bailout” rate), surrender charges will be waived for a certain time period, allowing the contract owner to “bail out” of the contract without charges. The premature withdrawal penalty of Section 72(q) will apply if the owner is under age 59-1/2 and no other exception to the penalty is available. “Bailout rate” annuities were much more popular in the 1980’s and 1990s than they are today.


Question 2-4

PROPERTIES


Settlement Options

When an annuity product reaches maturity date, the contract holder must elect the manner in which his or her benefits will be paid. This is known as the “settlement option” and the options come in many forms.

Though most settlement options involve a life income, two do not. Those two are the fixed amount and the fixed period payout options. The other settlement options involve payments for life, or life contingencies.


With the fixed amount settlement option, the amount of the benefit payment is decided upon. Then, the period of time over which this set benefit amount will be paid is calculated using the contract value of the annuity, or a portion of it, and interest.

The benefit amount is usually issued monthly, quarterly, semi-annually or annually. When the designated amount has been paid for the period calculated, the entire value of the contract will have been paid out.

The fixed period settlement option is similar to the fixed amount option, except it is the period of time that is known and the benefit payments must be calculated using the contract value, or a portion of it, and interest.

When the calculated payments have been issued for the period designated, the entire value of the contract will have been paid out.

Settlement Options


The life annuity settlement option is commonly referred to as “annuitizing” the contract value. It provides the annuitant with a life income without a refund on any of the contract value.

The life income is calculated using the accumulated contract value at the time of settlement. The calculation uses annuity tables, which indicate the probabilities of living for years into the future.

The older the age of the annuitant the higher the benefit payments. When the annuitant dies, all payments stop and there are no payments issued to others.

Settlement Options


Question 2-5

PROPERTIES


Settlement Options

The life income with period certain settlement option combines a life annuity with a fixed period option. An income is paid for the life of the annuitant, with the further provision that if the annuitant dies before a fixed period, such as five, ten or twenty years, has been completed, payments will be continued to the designated beneficiary for the balance of the fixed period.

The life income with refund payout settlement option is a variation on the life income with period certain option. In this case, an income is paid for the life of the annuitant, but if he or she dies after only a few years, payments will continue until all of the original contract value, usually not including the interest used in this calculation, is paid to the designated beneficiary. The refund payments are made in the same installments as those paid while the annuitant was still alive.


Under the joint and survivor annuity payment settlement option, benefit payments provide a life income for two annuitants and sometimes more. Payments continue as long as either (or any) of the annuitants is living.

The calculation of the benefit payments takes into consideration the probabilities of both and either of the annuitants living for years into the future. The amount of the benefit payments may remain the same upon the death of one of the annuitants (known as joint and 100% survivor), but they traditionally provide for a reduced benefit payment (joint and 50% or joint and two-thirds) upon the death of one of the annuitants.

The reduced payment option upon the death of an annuitant allows larger benefit payments to be issued when two (or more) individuals are relying on them for life income.

Settlement Options


With the joint and survivor with period certain settlement option, the income being paid to the annuitants will operate as a standard joint and survivor annuity option, with the further provision that should both annuitants die within a short period of time after the commencement of benefits, payments will continue to a beneficiary for the balance of the period certain.

Settlement Options


Variable Annuity Settlement Options

o Fixed Amounto Fixed Periodo Life Annuity Life Income with

Period Certaino Life Income with Refund Payouto Joint and Survivor Annuity

Payment

• Joint and 100% Survivor• Joint and 50% Survivor• Joint and Two-Thirds Survivor

o Joint and Survivor with Period Certain

Surrender Charges

Insurance companies that sell variable annuity contracts consider them to be long-term investments for the contract holder. In order to assist contract holders in adopting the same view, variable annuity contracts traditionally provide for the imposition of surrender charges against the complete or partial withdrawal of assets during the early years that the variable annuity is in force.

The charges are highest in the early years of the contract and decline with each succeeding year until they disappear altogether. It is common for surrender charges to be scheduled for five to nine years.

For example, an eight-year schedule would impose a charge equal to 8% of any amount withdrawn during the first year the contract is in force. This charge would decline 1% for each year thereafter until, after the contract has been in force for eight years, surrender charges no longer apply.

Surrender charges are also commonly referred to as “contingent deferred sales loads.”


Question 2-6

PROPERTIES


Common Provisions

A variable annuity contract is most beneficial to the contract holder and the issuing insurance company when it provides adequate value to the contract holder while earning an adequate return for the issuing company.

The contract holder receives value when the guaranteed rates and benefits under the contract provide the growth and security sought when the contract was purchased. The issuing company, in turn, must receive an adequate return on the contract so that it can provide the services under the contract that the customer needs.

These services are traditionally paid for through the imposition of some, or all, of the following charges and fees.


Contract Fees and Penalties

Many contracts have administration fees that are charged against the contract in a flat amount on an annual basis. This administration fee, typically $30 to $40 per year, pays for the ongoing maintenance of the contract, preparation of statements, premium notices, mailings and other customer services.


The charge assessed against the guaranteed account is indirect. It is an interest margin and the size of it depends on how large the expenses are that need to be covered.

The issuing company’s investments in corporate bonds and government securities produce a certain rate of interest earned by the insurance company through its general accounts. The insurance company then credits a lesser rate to the assets in the guaranteed account. The difference in the two rates of interest is the interest margin, or “haircut.”

Companies attempt to manage the margins so interest rates they guarantee do not fluctuate as frequently as the bond markets. Companies can hold some cash reserve against rising and falling interest rates. This allows the company to remain competitive with other insurance companies.

Interest Margin


Question 2-7

PROPERTIES



The Mortality and Expense charge, commonly referred to as the “M&E charge,” is a percentage subtracted from the values of the variable sub-accounts.

The M&E charge pays for three guarantees to the contract holder:

1. The guaranteed death benefit under the contract

2. The fixed payout options that guarantee that a certain amount will be paid for the life of the annuitant

3. The guarantee that contract expenses will increase no more than the maximums stated in the prospectus

Overall M&E charges typically range from 1% to a little over 1.5%.


Investment management fees are charged directly to each variable account and impact the performance figures of the account. The fees cover the professional management of the assets invested in the variable sub-account.

Total investment management fees, which combine the advisory fee and operating expenses incurred by the investment advisor to the sub-account, averages .77% according to industry reports.



Contract holders of variable annuity contracts are permitted to transfer assets among the various sub-accounts within the contract without the necessity of selling assets in one sub-account in order to put assets in another sub-account (and incurring income taxes as a result).

Generally, insurance companies will allow variable annuity contract holders to make a certain number of transfers each year free of charge. However, when that number has been exhausted, a fee is imposed on subsequent transfers that typically range from $10 to $20 per transfer. Short term fees may also apply.



Lesson 2 Quiz

PROPERTIES






Lesson 3Nonqualified Annuities


Lesson 3 Objectives


1. Explain the concept of the multi-faceted investment program.

2. Discuss the part the individual variable annuity contract plays in the savvy long-term investment program.

3. Detail the ability of the savvy investor to establish stability and safety among investments in a variable annuity contract through diversification of assets.

4. Explain the benefits of dollar cost averaging on the purchase of investment shares under a variable annuity contract through regularly scheduled premium payments.

5. Compare and contrast the advantage of tax-deferred growth of investments as compared to the growth of investments that are currently taxed on earnings.

6. Discuss the advantages of compound interest in regard to long-term wealth accumulation.

Lesson 3: Non Qualified Annuities

Individually Owned Retirement Plan

Intelligent investors develop a multi-faceted approach to attaining their long-term financial goals. With the advantages of compound interest, many of these savvy investors maximize their options for tax-deferred growth on their assets.

First, they take full advantage of any corporate retirement plan in which they are eligible to participate. They make the maximum contribution to the corporate plan permitted under the plan document and the Internal Revenue Code.

As discussed later, in Lesson IV, qualified retirement plans allow investors to contribute to retirement plans on a tax-deferred basis. In addition, the earnings continue to accumulate on a tax-deferred basis until they are distributed from the plan.


To further the advantage of tax-deferred growth on investments, the savvy investor will establish an individual variable annuity contract. Much like mutual funds, variable annuities are funded with after-tax dollars.

However, unlike mutual funds, variable annuities offer the investor tax-deferred growth on the investments made into the contract. Tax-deferred growth of earnings makes the individual variable annuity function as an individual retirement plan.

When coupled with qualified retirement plans, after-tax investments on wages, and supplemental government income programs, the individually purchased annuity offers savvy investors many advantages in preparing for saving their personal retirement living expenses.

Individually Owned Retirement Plan


Question 3-1

PROPERTIES


Contribution Issues

Regular and consistent premium payments allow the contract owner the opportunity to engage in dollar cost averaging.

Dollar cost averaging is paying a fixed amount of premium at regular intervals -- monthly, quarterly, semi-annually, or annually – regardless of the share values of the selected variable accounts (or the current interest rate on new premiums paid into the guaranteed account).

The equal dollar amounts will result in relatively fewer variable account shares being purchased when share values are higher and more shares when share values are lower.


Question 3-2

PROPERTIES


Dollar Cost Averaging

Consider Mr. Kim, who has paid $200 of premium into the variable account each month. The share value of $10 at the time of the January premium payment results in 20 shares being purchased. As the share value goes up, fewer shares are purchased. When it goes down, more shares are bought.

For ease of calculation, we bring the share value back to $10 at the end of May (5 months X $200 = $1000 premium paid) so that we can look at what happened.

Since 107.46 shares have been purchased and each share is worth $10.00 currently, the value in the account is $1,074.60 at that point.


Time PremiumShare Value

Shares Purchased

Jan $200 $10 20

Feb $200 $12 16.67

March $200 $9 22.22

April $200 $7 28.57

May $200 $10 20

Totals $1,000$9.60 Avg

107.46 Shares

Dollar Cost Averaging

There is an automatic benefit to dollar cost averaging due to the fact that more shares are purchased when the share values are lower and fewer when share values are higher.

As we see in the example, the average share value at the time of purchase was $9.60. But the average cost of a share purchased was $9.31 ($1,000 premium divided by 107.46 shares = $9.31).

This is a $0.29 per share gain. This gain is always the case with dollar cost averaging and the more volatile the accounts, the more gain there will be. Of course, the share value of the account must eventually at least regain the starting level for the gain in shares to be of beneficial effect.

It should be noted that dollar cost averaging does not guarantee a profit nor can it protect against a loss in a declining market.


Question 3-3

PROPERTIES


Diversification Issues

Many people desire a certain measure of safety with respect to the funds they are saving or investing as well as with respect to the earnings the funds will generate. In the variable annuity contract, it is diversification of investments that brings this safety.

Diversification under a variable annuity product is a joint effort that includes the contract holder. The variable annuity sub-account will have diversification in keeping with the investment objective of the account.

However, the variable annuity buyer must attain this diversification by selecting those accounts that provide the desired level of diversification when considered along with the buyer’s other investments and savings. It should be noted that diversification does not guarantee a profit not protect against a loss in a declining market.


Wide Range of Investment Approaches

The savvy investor understands that a successful financial program certainly must invest in stocks and bonds if long-term wealth accumulation goals are to be met.

Variable annuities have funds available that cover a wide range of investment approaches. Some of these funds may be described as:

· Growth

· Aggressive Growth

· Growth and Income

· Corporate Bonds

· Government Bonds


· Balanced

· International Stocks

· International Bonds

· Index Funds such as the S&P 500

Add to this list, which is not a complete list, a guaranteed interest account, and the buyer has a multitude of choices.



Not all variable annuities have all of these funds, but, on the other hand, they often have more than one of a particular type. These funds are managed by professionals and the buyer merely allocates how much of his or her payments are going into the funds selected.

The buyer usually has no restrictions as to what percentage or amount may be allocated to what account. And, he or she can change the allocation, or move the money from one fund to another as permitted by the variable annuity contract.

As a result, the buyer is able to allocate as much or as little as he or she wishes to various funds and can attain a level of safety and growth that best reflects his or her tolerance level as indicated on the risk/reward spectrum.



Accumulation for Retirement Issues

Although annuities outside of qualified retirement plans can be sued for many purposes, one of the most attractive and frequent uses is in retirement planning. Since people are living longer than at any time in history, there are more retirement years to be planned for an, particularly, to be paid for. As baby boomers are heading into their retirement years, they have begun to seriously plan for this phase of their lives. A shift away from employer-funded plans has given individuals even more reasons to take the lead in planning for and funding their retirement years.

This increased attention has caused people to look more closely at additional vehicles to supplement Social Security and qualified retirement plans. The variable annuity can be an attractive option.


As with many financial planning strategies, earlier is better when deciding to start saving for retirement. Consider the difference in funds available based on starting at different ages. If Mrs. Smith, the annuity holder, begins contributing $200 per month to an IRA at age 40, she will have accumulated $138,598 at age 65 (assuming a 6% interest rate).

The same monthly amount started at age 50 would result in a sum of $58,164 at age 65. Waiting until age 60 severely cuts down the available funds, resulting in a sum of just $13,594.

If Mrs. Smith elected a life settlement option under the annuity contract at age 40, her monthly benefit would be $812. Under the annuity started at age 50, the benefit would be $341, while under an annuity started at age 60, she would receive only $82 each month.



The usefulness of starting early can be illustrated another way. Assume that Mrs. Smith, with the help of her financial planner, determines she needs $500 per month at retirement to supplement her retirement income from other sources. If Mrs. Smith begins contributing into an annuity at age 40, she will need to pay in $123 per month. If she waits until age 50 to begin, she will have to pay in $293 each month. Waiting until age 60 to begin contributing to the annuity would require a monthly payment of $1,223.

Clearly, starting early is the best course of action for this type of retirement planning.



Withdrawal Issues and Penalties

In discussing the advantages of tax-deferred growth on investment earnings under a variable annuity contract, no discussion would be complete without a discussion of the premature distribution penalty.

The Internal Revenue Code imposes a penalty of 10% on any taxable amount of a distribution received from a non-qualified variable annuity contract if the contract holder is under the age of 59-1/2 at the time of the distribution.

Consider Mrs. Siegal in our tax-deferred growth example. Looking back at her 20 year tax-deferred growth of $98,846, we can see that, if she is under age 59-1/2 at the time she requests distribution of the amount, she will pay the 10% premature distribution penalty on the tax-deferred portion of her distribution.


Question 3-4

PROPERTIES


Withdrawal Issues and Penalties

Because she funded the variable annuity at a rate of $2,000 per year with after-tax wages, she has accumulated an investment basis of $40,000. This leaves Mrs. Siegal with a taxable distribution of $58,846.

The premature distribution penalty will be applied to this figure for a penalty tax of $5,884.60.

The penalty will be added to the tax owed on the taxable ordinary income amount of the distribution leaving Mrs. Siegal with an after-tax and after-penalty distribution of $76,484.52 (This gross distribution of $98,846 minus $22,361.48 of income tax and premature distribution penalty).


Premature Distribution Penalty

The premature distribution penalty does not apply to a distribution from an individual variable annuity contract if made after the taxpayer attained age 59-1/2; dies or becomes disabled.

Other areas where the penalty does not apply include:

· An allocable portion of an investment in a variable annuity contract before August 14, 1982

· Under an immediate annuity contract

· Under a qualified funding asset such as any annuity contract purchases because of a liability to pay for damages from physical injury or sickness or as a part of a series of substantially equal periodic payments made (not less frequently than annually) for the life or life expectancy of the taxpayer or the joint lives or joint life expectancies of the taxpayer and his designated beneficiary.


Premature Distribution Penalty

Of course, the premature distribution penalty imposed by the IRS should not be confused with any surrender charges that may also apply to a premature distribution under the terms of the variable annuity contract.


Lesson 3 Quiz

PROPERTIES






Lesson 4Qualified Annuities


Lesson 4 Objectives


1. Discuss the differences between a “qualified annuity” and a “nonqualified annuity” and how they relate to the provision of retirement benefits.

2. Explain how variable annuities can be an effective product for employers to invest in for the provision of retirement benefits to their employees.

3. List by name, the various types of retirement programs that can be adopted through a variable annuity contract.

4. Discuss the elementary differences between the operation and funding of the various types of retirement programs available through qualified variable annuities.

Lesson 4: Qualified Annuities

Variable Annuities in Qualified Plans

Variable annuities used in qualified plans, as briefly discussed in Lesson 1, is a contract through which an employer may offer a retirement plan to its employees. This purpose is for the tax deferred accumulation of assets intended to supplement their living expenses after they retire.

The term “qualified” refers to the provisions of the retirement plan being written and administered in such a fashion that it satisfies the rather stringent requirements of the Internal Revenue Code for maintaining tax deferred status.

In other words, if the retirement plan purchased through a variable annuity satisfies coverage, participation, and benefit accrual rules.

The plan itself is tax-deferred and funding with a variable annuity does not enhance or alter this treatment.


Designed to make certain the plan does not discriminate in favor of certain key employees (such as the owner and officers), then all contributions to, and earnings derived through, the plan are tax deferred.

Contributions are deductible by the employer and excludable by the employee (for example, 401(k) plans) or possibly deductible (for example, a traditional IRA). Earnings on investments are tax deferred to the individual who will ultimately receive them in the form of a distribution.

Assets accumulated in the qualified variable annuity are invested among the various sub-accounts offered under the contract. Some plans permit individual employee participants to actively direct the investment of the assets in their individual accounts among the sub-accounts (providing them with one of the benefits of an individually purchased nonqualified variable annuity).


Variable Annuities in Qualified Plans

Qualified vs. Nonqualified Variable

The primary difference between a qualified and nonqualified variable annuity is that contributions into the qualified variable annuity may be tax deferred to the employee (that is, not currently taxable), whereas only the earnings on contributions into a nonqualified variable annuity are tax deferred.

There is one minor exception to this general rule—the Roth IRA may only be funded with after-tax dollars. We will discuss this in more detail later.

Another key difference for most qualified variable annuities is that they may only be established by employers for a group of employees.

As you can see, the terms “qualified” and “nonqualified” have absolutely nothing to do with the quality and stability of the variable annuity or of the insurance company offering it.


Question 4-1

PROPERTIES


Defined Benefit Plans

Defined benefit plans are usually recognized as the “traditional” retirement plan. They are also commonly referred to as “pension” plans or “pure pension” plans.

The pension plan is more familiar to the older generation of Americans and is recognized as the type of retirement benefit most of our parents have received.

Basically, a defined benefit plan does not provide for individual participant accounts under which each employee may be able to see “how much money I have” at any given point in time.



A defined benefit plan functions much like a fixed annuity. The Internal Revenue Code requires defined benefit plans to permit the participant to calculate what his or her monthly retirement benefit will be by way of a “definitely determinable” formula.

For example, a fully vested participant in a given defined benefit plan may be entitled to a monthly annuity guaranteed for life that is equal to 30% of his or her highest monthly compensation earned during his or her employment.


Question 4-2

PROPERTIES



This formula is used by an actuary to determine how much money the employer must place into the plan in the present year to fund the future value of the benefits promised under the plan.

Funding of defined benefit plans is the responsibility of the employer. It is determined using actuarial calculations and is fixed regardless of the market performance of underlying plan investments.

In other words, the employer may have to contribute additional dollars to meet the funding requirements in a down market or if the original actuarial calculations were incorrect.



Assets are traditionally distributed to participants from defined benefit plans at the attainment of normal retirement age or an early retirement age in the form of an annuity or in the form of survivor benefits to the participant’s beneficiaries in the event of his or her death.

Some defined benefit plans will allow for distributions in the event of a participant becoming disabled and upon the termination of covered employment by the participant.


Defined Contribution Plans

Defined contribution plans are also referred to as “individual account plans” because each participant is provided a sub-account within the plan to which specific dollar amounts allocated and vested to each participant may be identified at any given point in time.

Defined contribution plans come in three basic types: Profit Sharing, 401(k) and Money Purchase.


Profit Sharing Plans (PSP)

A profit sharing plan or (PSP) is established by the employer to provide for participation in corporate profits by participants. Most PSPs allow for discretionary contributions on an annual basis, but once established, the plan must provide a definite predetermined formula for allocating the contributions into the participant accounts.

Benefits attributable to employer contributions to a profit sharing plan generally may not be distributed without penalty until the participant retires, becomes disabled, dies, or attains age 59-1/2, and are often issued in a lump-sum amount. Any premature distribution penalty may be avoided by rolling the distribution over into another qualified plan or an IRA.


Question 4-3

PROPERTIES


401(k) Plans

A 401(k) plan is usually a profit sharing plan (PSP) with written provisions permitting employees an opportunity to defer a percentage of their salary on a pre-tax basis into their individual account within the plan.

Because the employee is given an option to receive the salary at present in the form of “cash” or to defer taxation and receipt until a later time on a deferred basis, 401(k) plans are also commonly referred to as “CODAs” or “Cash or Deferred Arrangements.”

The provision under the Internal Revenue Code (IRC) that permits tax-deferred salary contributions is found under Code Section 401(k) (thus, the name of the plan). The employer may draft the plan to permit matching contributions from the employer tied to the amount employees defer into their accounts.


Question 4-4

PROPERTIES


401(k) Plans

As earlier noted, 401(k) plans are usually profit sharing plans. This permits the employer an opportunity to add additional funds (beyond a matching contribution) into employee accounts. This adds maximum flexibility when attempting to meet the funding and allocation provisions for qualification.

Benefits attributable to employer contributions to a 401(k) plan generally may not be distributed without penalty until the participant retires, becomes disabled, dies, or attains age 59-1/2, and are usually issued in a lump-sum amount.

Any premature distribution penalty may be avoided by rolling the distribution over into another qualified plan or an IRA.


Money Purchase Plans

A money purchase plan provides funding from the employer only and the contributions are mandatory. The amount of contributions to a money purchase plan is based upon a percentage of participant salaries.

A typical funding formula for a money purchase plan might read: “The company shall contribute each year an amount on behalf of each participant equal to 10% of his or her compensation.”

Failure to make the mandatory annual contribution to a money purchase plan will result in the imposition of penalties by the Internal Revenue Service.


Money Purchase Plans

They are called money purchase plans because the account balance at retirement is traditionally used to “purchase” a monthly fixed annuity payable for life to the participant.

Money purchase plans generally may not permit “in-service” distributions or (benefits payable prior to termination of employment). This means hardship distributions or any other distributions prior to retirement, death, disability or severance of employment are prohibited. However, a small percentage of money purchase plans do permit participant loans.


Question 4-5

PROPERTIES


SIMPLE

In addition to the big three of defined contribution plans, there are two alternative defined contribution plans available to small employers.

Savings Incentive Match Plan for Employees (SIMPLE)

A SIMPLE plan is a relatively recent retirement program available since 1997. A SIMPLE program (which may be either a 401(k) arrangement or an IRA arrangement) is available to employers who have employed 100 or fewer employees who earned $5,000 or more in compensation during the previous year.



o Available to small employerso Available since 1997o May be a 401(k) or IRA

arrangemento 100 or fewer employeeso Salaries of $5,000 or more during

previous year

SIMPLE

Employees may defer up to $11,500 (in 2012) of their salary into their SIMPLE plan account. “Catch-up” contributions may be made by employees aged 50 or more. The employer must match the first 3% of salary deferred on a dollar for dollar basis (100% match up to the first 3%).

Alternately, SIMPLE plan sponsors may elect to provide a nondiscretionary contribution to all eligible employees equal to 2% of their compensation (whether or not they actively defer any salary into their account).


SIMPLE

SIMPLE Plans are relatively easy to adopt and administer (many of the complex qualification tests do not apply to SIMPLE arrangements). They are completely portable when established under an IRA arrangement. All contributions immediately vest to the participants.



o From $10,000 (in 2005) to $11,500 (in 2012) may be deferred

o “Catch-up” contributions allowed for employees 50 and older

o 100% match up to the first 3%o Nondiscretionary contribution of

2% to eligible employeeso Easy to use and administero Immediate vesting of

contributions

Simplified Employee Pension (SEP)

A SEP is a Simplified Employee Pension that is established by providing eligible employees with an individual retirement account into which the employer makes direct tax-deductible contributions.

Each employee who is age 21 or over, who earns at least $550 for the year 2012, and has performed services for the employer in at least three of the immediately preceding five calendar years is eligible to participate in the SEP.


o Available to small employerso Employees age 21 or overo Earning at least $550 in 2012o Performed services in 3 of the

past 5 years


Pretax contributions to a SEP are limited to the lesser of:

1. 25% of the employee’s compensation (excluding the SEP contribution)

2. $50,000. The compensation limit is statutorily capped at a maximum of $150,000 (subject to cost of living adjustments)

For the year 2012, the maximum annual contribution into a SEP account is $50,000. Contributions to SEP plans are immediately vested and are nonforfeitable.

Prior to January 1, 1997, employers could adopt a SEP that featured salary reduction features for employees. The SAR-SEP has been replaced by the SIMPLE plans.




o Limited to the lesser of 25% of compensation or $50,000

o Capped at a maximum of $200,000

o Max annual contributions for 2012 is $50,000

o Immediate vesting of contributions and nonforfeitable

Individual Retirement Accounts (IRAs)

A traditional individual retirement plan is a personal retirement savings program toward which eligible individuals may contribute both deductible and nondeductible payments with the benefit of tax-deferred build up of income.

The Internal Revenue Code limits the amount of annual contributions into any IRA to a maximum of $5,000 (for 2012). “Catch-up provisions are available for those age 50 and older, and are the smaller of $6,000 or the individual’s taxable compensation for the year. These amounts may or may not be deductible depending upon whether or not the account holder is eligible to participate in a qualified plan at his or her place of employment.

An individual may have more than one IRA, but the annual deduction limit for contributions applies to the individual and not to each account owned by the individual.


Question 4-6

PROPERTIES


Roth IRA

A Roth IRA is a personal retirement savings program toward which eligible individuals may contribute nondeductible payments only with the potential benefit of tax-free build up of income. The annual limit on contributions into a Roth IRA is $5,000 (in 2012) (including contributions to a traditional IRA). “Catch-up provisions are available for those age 50 and older and are the smaller of $6,000 or the individual’s taxable compensation for the year.


Roth IRA

A Roth IRA must clearly be designated as such at the time of establishment, and that designation cannot later be changed. The recharacterization of a Roth IRA will require new documents. With respect to both traditional and Roth IRAs, some individuals may also contribute to such plans for their spouses.

There are two kinds of traditional and Roth individual retirement plans. They are: individual retirement accounts and individual retirement annuities. For purposes of this course, we will focus on the Individual Retirement Annuity.


Individual Retirement Annuity

This may be an annuity or an endowment contract issued by an insurance company. (But an endowment contract issued after November 6, 1978 will not qualify.) The contract must be nontransferable.

A contract will be considered transferable if it can be used as security for any loan other than a loan from the issuer in an amount not greater than the cash value of the contract.

Even so, a policy loan would cause the contract to cease to be an individual retirement annuity or endowment contract as of the first day of the owner’s tax year in which the loan was made. Contracts issued after November 6, 1978 may not have fixed premiums.


Individual Retirement Annuity

With respect to traditional individual retirement annuities, distribution must begin by April 1 of the year after the year in which the owner reaches age 70-1/2 and the period over which distribution may be made is limited.

With respect to both traditional and Roth annuities, required minimum distribution requirements are applied upon death of the owner.


Lesson 4 Quiz

PROPERTIES






Lesson 5Taxation Issues


Lesson 5 Objectives

After completing this lesson you will be able to:

1. Explain the basic terms and concepts relating to income taxation of distributions from variable annuity products.

2. Provide an analysis of the income tax issues raised by the accessing of loans and partial surrenders from variable annuity programs.

3. Discuss the tax-free exchange of variable annuity products for newer variable annuity contracts or other life insurance products.

4. Discuss various issues of concern regarding the estate taxation of variable annuity contracts.

Lesson 5: Taxation Issues

Taxation of Annuity Benefit Payments

Because variable annuities accumulate substantial amounts of money that are withdrawn or distributed in the future, their income tax aspects are of importance. So too are their estate and gift tax implications.

As we have touched on in earlier sessions, contributions to variable annuity contracts are non-deductible if the contract is non-qualified.

However, contributions to variable annuities that have been purchased through qualified retirement plans are usually deductible as plan contributions.



The interest or earnings credited to a variable annuity, which meets the qualifications of the Internal Revenue Code, are not taxed at the time they are credited, provided that they remain inside the contract and are not withdrawn or distributed.

One of the key exceptions to this general rule is that if premiums are paid into a non-qualified deferred annuity that is owned by a corporation or other entity not considered a natural person under the law, interest or earnings on the contributions are taxable to the non-natural entity in the year they are credited to the account.


Question 5-1

PROPERTIES



A variable annuity owner may elect a fixed payout or a variable payout, with a number of options available with either of the two. Income taxation of the payout depends on which of the two options has been selected although the principles involved are quite similar.

The basic rule is that the purchaser is to receive the investment in the contract in equal tax-free installments over the payment period. The rest of the amount received each year is to be included in gross income. Thus, each payment is taxable in part and tax-free in part.


Fixed Payout

With respect to a fixed payout, determining what portion is taxed and what portion is not taxed is made using an exclusion ratio, which may be expressed as a fraction or as a percentage. It is arrived at by dividing the investment in the contract by the expected return.

The exclusion ratio is applied to each annuity payment to find the portion that is excludable; then the balance is includable in taxable income in the year it is received.


Variable Payout

With respect to a variable payout, the amount to be paid out each year is not known at the beginning. Therefore, it is the excludable portion that is calculated. This is done, by dividing the investment in the contract, by the expected return multiple contained in rate tables provided under the Internal Revenue Code regulations.

In layman’s terms, the expected return under a variable annuity payout is determined by dividing the investment in the contract by the number of years over which it is anticipated the annuity will be paid (as calculated using the IRS tables referred to).

For variable annuities that contain investments made after June 30, 1986, generally the unisex tables contained in the regulations must be used.


Question 5-2

PROPERTIES


Investment Basis

As previously noted, the basic rule of taxation on variable annuity payouts is that the purchaser is to receive his or her investment in the contract over a series of equal tax-free installments scheduled over the payout period. This is referred to as a “return of basis.”

The investment basis (also known as the “cost basis”) in the variable annuity contract is best described as the investment in the contract comprised of the gross premium cost or other consideration paid for the annuity contract. Because these investment payments were made with after-tax dollars, they are returned tax-free during the payout period.


Expected Return

The expected return from the annuity contract is the figure into which the investment in the contract is divided when calculating the annuity’s exclusion ratio. Generally speaking, expected return is the total amount that the annuitant can expect to receive under the contract.

Fixed period and fixed amount annuity payouts are relatively easy to calculate. Variable payouts based on life expectancies make calculating the expected return a little more difficult.

The expected return, in this instance, must be calculated with the life expectancy multiple (or multiples) taken from the annuity tables as set forth by the IRS.


Loans and Assignments

The expected return from the annuity contract is the figure into which the investment in the contract is divided when calculating the annuity’s exclusion ratio. Generally speaking, expected return is the total amount that the annuitant can expect to receive under the contract.

Fixed period and fixed amount annuity payouts are relatively easy to calculate. Variable payouts based on life expectancies make calculating the expected return a little more difficult.

The expected return, in this instance, must be calculated with the life expectancy multiple (or multiples) taken from the annuity tables as set forth by the IRS.


Question 5-3

PROPERTIES



The taxation of loans and assignments from a variable annuity contract can best be illustrated by the following example. Assume Mr. Gonzalez purchased an annuity contract in 1990 with a single premium of $100,000. Currently, the annuity’s cash surrender value is $150,000.

Mr. Gonzalez wishes to borrow from his local bank for an entrepreneurial venture. He assigns to the bank an interest in the full value of the annuity. At the time of the assignment, Mr. Gonzalez will have taxable income of approximately $50,000. This is calculated by taking the cash surrender value of the annuity immediately prior to the assignment ($150,000) and subtracting Mr. Gonzalez’s investment in the contract ($100,000).

Because Mr. Gonzalez is under age 59-1/2 at the time of the assignment, he is also going to be responsible for the 10% premature distribution penalty on the taxable amount of the assignment. This results in a penalty of $5,000 in addition to the income tax owed on the $50,000 deemed taxable income.


Loans made under qualified variable annuity contracts are subject to different rules not addressed in this course. Loans from Individual Retirement Annuities are prohibited.



Partial Withdrawals

The taxation of partial withdrawals (also commonly referred to as “partial surrenders”) from variable annuity contracts can be tricky.

Changes in the tax laws over the last several decades requires precise knowledge of the date upon which the contract was entered into to determine which income tax rule applies to a partial withdrawal.

If an annuity was entered into after August 13, 1982, a partial surrender will be taxed under the “interest first” rule. If the annuity was entered into prior to August 14, 1982, a partial withdrawal will be taxed under the “cost recovery” rule.


Partial Withdrawals

Under the “interest first” rule, amounts received are taxable as income. This is to the extent that the cash value of the contract immediately before the partial withdrawal or surrender exceeds the investment in the contract.

The investment in the contract, paid with previously taxed money, is then received without tax. Thus, all interest and earnings are distributed before any of the investment in the contract.


Partial Withdrawals

Under the “cost recovery” rule, the owner receives first whatever investment in the contract he or she has paid before August 14, 1982, which has been taxed previously, on a tax-free basis.

Withdrawals of amounts that are the investment in the contract continue on a tax-free basis until that entire amount has been recovered. Interest and earnings are taxed only after the recovery of the investment paid before the 1982 date.


Partial Withdrawals

An annuity entered into before August 14, 1982 may have some of its premiums paid before the rule change and some of them afterward.

In such a case, amounts withdrawn are allocable first to investments made prior to August 14, 1982, then to income from investments made after August 13, 1982, and finally to investments in the contract made after August 13, 1982.

In other words, the sequence is tax-free, then fully taxed, and then tax-free.


Question 5-4

PROPERTIES


Complete Surrender

Complete surrenders of variable annuity contracts are taxed in a manner similar to loans and assignments. If an annuity holder surrenders the contract and receives the complete surrender value under the contract, the holder must pay income tax on the difference between the amount he has received and his basis in the annuity. For example, Ms. Chin owns a variable annuity with a cash surrender value of $100,000 and her investment basis is $60,000. When Ms. Chin completely surrenders the variable annuity to the issuing insurance company, she will have taxable income of $40,000. This amount is arrived at by subtracting her investment basis of $60,000 from the $100,000 cash surrender value.

As with all other distributions from variable annuity contracts, if Ms. Chin is under age 59-1/2 at the time she surrenders the contract, she will have to pay the 10% premature distribution penalty on the $40,000 of taxable income.


Question 5-5

PROPERTIES


“Trade-In” Contracts

Variable annuity owners sometimes want to “trade-in” their contracts for newer ones because of interest rates on the guaranteed account, because of services or types of investments available with a new contract, because of insurance company solvency concerns, and for other reasons. Care should be exercised in these situations in light of FINRA Rule 2821 which establishes guidelines for the exchange of variable annuities, among other things.


Reasons to Make an Exchange

The reason the owner of a variable annuity contract would want to make an exchange, instead of merely cashing in one contract and purchasing another, is so that there will be no taxable event at the time of the exchange. That is, there will be no inclusion of income subject to income tax. Tax-free exchanges of annuity and life insurance contracts are controlled by Internal Revenue Code section 1035.


That section says that the following exchanges may be made without current income taxation:

1. An annuity contract for another annuity contract

2. A life insurance policy for an annuity contract

3. An endowment contract for an annuity contract

4. A life insurance policy for another life insurance policy

5. A life insurance policy for an endowment contract; and

6. An endowment contract for an endowment contract that will begin making payments no later than payments that would have commenced under the old contract.

Reasons to Make an Exchange


IRC Section 1035 Exchanges

Note that there is no provision for exchanging an annuity contract for a life insurance contract. Also, Internal Revenue Code Section 1035 does not apply to qualified variable annuity contracts because the qualified plans they relate to already have separate rollover provisions elsewhere in the Internal Revenue Code.


Estate Taxation Issues

Variable annuities are property and usually are a part of the estates when people die while owning them. A particularly successful program of setting aside money and selecting funds which perform well can result in a substantial contract value that can negatively impact the final calculation of the estate tax.



A variable annuity in the accumulation phase will have a death benefit payable to a beneficiary. When the owner and annuitant dies, the value of the annuity, presumably the death benefit is included in his or her estate.

When an owner who is not the annuitant dies, the value of the annuity is what is referred to as the replacement cost. This is the amount that it would cost to purchase a comparable annuity contract at the time of owner’s death.


When an annuity is in the payout phase, the death benefit in the contract usually no longer applies. The remaining value of the annuity depends on what types of payout provisions are operating. If a life income with no term certain or refund is in effect, nothing would be paid to a beneficiary and, for that reason, nothing would be includable in the owner’s estate.

Where there is a fixed period or fixed amount option selected, and all payments have not yet been received, the value of the unpaid installments would be includable.



Similarly, where there is a life income with a period certain in effect and the annuitant-owner dies before the period certain has run, the value of unpaid installments is includable. The value to be included is the present value of the payments; that is, interest that would have been earned over the remaining period is subtracted from the total remaining installments.



Question 5-6

PROPERTIES


Gift Taxation Issues

Gift taxes regarding variable annuities can arise in two ways. One is when an individual on behalf of someone else purchases the annuity. Such a situation might be a grandparent providing an annuity contract for a grandchild. The Internal Revenue Code provides an annual exemption from gift taxation of any gift or combination of gifts that does not exceed $13,000 in value per recipient.

In this case, if the annual premium paid by the grandparent does not exceed $13,000 per year, the annual gift tax exclusion would apply. Married couples may combine their annual exclusion limit and double the annual exclusion limit to $26,000 per recipient.

The $13,000 gift tax annual exclusion is adjusted for inflation, and is rounded down to the next lowest multiple of $1,000.



Gift taxation can also apply where the annuity itself is gifted to another person. This is also referred to as an “assignment of the contract.” Such an assignment is subject to the gift tax unless the value of the contract is within the annual exclusion or the recipient of the contract is the owner’s spouse.

In addition, for variable annuities purchased after April 22, 1987, the assignment of the contract is also subject to income tax in the same manner as if it were surrendered. That is, the donor of the gift of the annuity is treated as having received the contract value less the investment in the contract. This goes beyond gift tax considerations.


Question 5-7

PROPERTIES


When the recipient disposes of the contract at a later date, he will have lower taxes to pay since the original owner had already been subject to tax for the gain that occurred under the contract prior to offering it as a gift.

When an annuity is given to another person as a gift, the value of the gift depends on several factors.

If it is given immediately after the purchase, the value is the price paid by the donor. That is, it is the amount of the premium paid.

If the gift is made after some increases in value have occurred, the gift value is the replacement cost. The replacement cost is the premium required to purchase a similar contract from the same issuer.



Lesson 5 Quiz

PROPERTIES






Lesson 6Licensing, Compliance and

Ethics


Lesson 6 Objectives


1. Describe the overall structure of the licensing and compliance framework for the marketing and selling of variable annuity contracts.

2. Explain the broker/dealer and registered investment advisor licensing requirements.

3. Discuss the disclosure and documentation obligations regarding sales literature, suitability statements and contract delivery of variable annuity products.

4. Explain the ethical practices required for the marketing and sales of variable annuity contracts.

Lesson 6: Licensing, Compliance and Ethics

Registered Products

Variable annuities are “registered products.” That is, they are registered with the Securities and Exchange Commission and are governed by federal and state securities laws.

The most prominent federal laws governing variable annuities are the Securities Act of 1933, which regulates variable annuities as an investment security, and the Investment Company Act of 1940, which regulates variable annuities as periodic payment plans.

State laws also play a prominent part in the marketing and sales of variable annuities. First, state law governs the issuing insurance company in that state where the company is domiciled and operates. Second, states have exclusive jurisdiction over the licensing of agents, the approval of insurance policies and contracts, and the marketing of insurance products, including variable annuities.


Registered Products

There is a self-regulatory organization charged with the regulation of marketing and sales activities of variable annuities. This is the Financial Industry Regulatory Authority, or “FINRA,” for short.

For an individual to market and sell variable annuities he or she will need to be a licensed agent or sales representative in his or her state as well as a registered representative with the proper licenses and registrations as administered and supervised by the FINRA and the Securities and Exchange Commission.

The individual who wants to sell in more than one state must be mindful of the registration and licensing requirements of each state, as they tend to vary.


Brokers/Dealers

To have the legal right to offer registered investment products for sale to the public, a business must be licensed and registered with the Securities and Exchange Commission. Once all requirements are met, the business becomes a registered broker/dealer.

In order for an individual to sell registered investment products, he or she must become a registered representative. A registered representative must be associated with a broker/dealer whose duty it is to see that the representative is qualified as a sales person and to supervise his or her marketing and sales activities.


The insurance company, that the broker/dealer is affiliated with, often takes responsibility for the licensing of the person as an agent. It often also assists the broker/dealer in administering its securities licensing activities. Since the representative often is licensed and contracted to sell other products of that company, this is a natural extension.

Brokers/Dealers


Question 6-1

PROPERTIES


Securities Licenses

A number of different securities licenses may be required in order for a registered representative to sell different types of securities. Since some of them are required at the state level, there are variations. All of these examinations are of the multiple-choice variety and are administered at registered testing locations on computer terminals.

Most licensing registration examinations allow test takers from 2 to 3 hours. The one notable exception is the Series 7 examination that is administered over a 6-hour period with a scheduled break halfway through.

In nearly all cases, a comprehensive grade of 70% is required to pass. Some examinations require the applicant to successfully answer 70% of the questions in each section of the examination.


The shortest route for an agent to getting licensed for the sale of variable annuities is the Series 6 license. The FINRA Series 6 license, once successfully tested for and attained, allows a registered representative to sell variable annuities, mutual funds (also known as “registered investment companies”), and variable life insurance policies.

A Series 7 license is a comprehensive license covering the required elements of the Series 6 license. It also covers three other FINRA licenses that permit the sales of limited partnerships, municipal securities, stocks and bonds.

The Series 7 licensing test is more difficult to successfully complete, because of the nature of products it grants authority to sell. A Series 7 student will be required to expend considerable effort in preparing for the Series 7 examination.

Securities Licenses


Securities Licenses

For agents who do not have the time it takes to prepare for such a comprehensive exam, they may take the incremental steps of passing the four separate licensing exams for the securities covered by the Series 7 license.

These tests are:

· Series 6 – Investment Company/Variable Products

· Series 22 – Direct Participation Programs

· Series 52 – Municipal Securities

· Series 62 – Corporate Securities

The North American Securities Administrators Association or (NASAA) Series 63, Uniform Securities State Law exam, is required of an agent where applicable state law requires state-level registration.


Question 6-2

PROPERTIES


Licenses Termination

A sales representative’s broker/dealer registration may terminate, because he or she has changed companies or because he or she is not doing the required quantity of business or because he or she has not paid applicable fees.

The representative may remain unaffiliated for up to two years. After that, the representative is required to successfully re-take the various tests again in order to affiliate with a broker/dealer.


Licensed Principals

Those who supervise registered representatives are required to also be licensed as “principals”, whether the representatives are engaged in sales or administrative functions that require licensing. As with the registered representative examinations, these tests are conducted at registered locations on computer terminals and require a score of at least 70% to pass.

In order to manage registered representatives who sell variable annuities, an individual must successfully complete the FINRA Series 26-Investment Company/Variable Contracts Principal examination.

In order to supervise and manage those registered representatives who have successfully attained their Series 7 license, an individual must pass the FINRA Series 24-General Securities Principal examination.


Investment Advisor (IA) and Investment Advisor Representative (IAR)

Many financial professionals who wish to provide investment advice on variable annuities and other instruments, register as Investment Advisor Representatives (IAR).

Most states require professionals who charge fees when providing advice to others about investments to register or become licensed.


IARs have three primary characteristics:

1. Provide advice or analysis on securities either by making direct or indirect recommendations to clients or by providing research or opinions on securities or securities markets.

2. Receive compensation in any form for the advice provided.

3. Engage in a regular business of providing advice on securities.

The IA firm holds the IA license, while the individual who performs services on behalf of the IA is registered as an IAR.

Investment Advisor Representative (IAR)


Question 6-3

PROPERTIES


Compliance Meetings

FINRA requires broker/dealers to have their registered representatives attend annual compliance meetings. These are meetings where a major portion of the time is devoted to compliance matters and issues. Those attending are reminded of the rules of conduct and of potential ethical and compliance pitfalls. Also, any new procedures required by the broker/dealer or mandated by the NASD, SEC or various states are explained and implemented.

FINRA holds the broker/dealer responsible if a registered representative does not attend the annual compliance meeting. For that reason, it is the broker/dealer that must impose any sanction on the registered representative.


The most common sanction is the suspension of the registered representative’s ability to do business through the broker/dealer until the compliance meeting has been successfully completed.

Compliance Meetings


Sales Literature

Prior to use, advertising and sales materials generated by issuing companies and broker/dealers must be reviewed by the Registered Principal and then filed with FINRA for comment. FINRA reviews the materials to make certain that they are not misleading and to assure the buying public that the materials adequately disclose all material facts relating to an investment in the product touted in the sales literature.

FINRA may request changes to materials or require additional information to be disclosed before the material may be offered to the buying public.

It is important to note that FINRA does not “approve” sales literature. In fact, it is improper for a registered representative or a broker/dealer to imply that any materials they present to the buying public have been “approved” by FINRA.


Sales Literature

Registered representatives may only use sales literature that has been approved by the broker/dealer. Most materials are prepared by the issuing company or come from the outside fund manager. Registered representatives may develop their own sales literature. However, the broker/dealer prior to use must approve it. This includes business cards and stationary.

Although FINRA prohibits the presentation of sales literature that is false or misleading, the broker/dealer is charged with enforcing these rules as it understands them.


Question 6-4

PROPERTIES


Continuing Education (CE)

FINRA administers the continuing education program for the securities industry in conjunction with other self-regulatory organizations. There are two mandatory programs: a Regulatory Element and a Firm Element.

The Regulatory Element requires that all registered individuals complete a computer-based training program within 120 days of the second anniversary of their registration approval dates and then every three years. This program focuses on compliance, regulatory, ethical, and supervisory subjects, as well as sales practice standards.


The Firm Element requires broker-dealers to establish annual formal training programs focused on keeping “covered persons” up-to-date on job and product-related subjects. Each broker-dealer must consider its size, structure, scope of business, and regulatory concerns and must maintain records documenting the content and completion of the Firm Element program.



Each broker/dealer must provide an annual continuing education program or Firm Element for all of its registered representatives. The annual compliance meeting is usually part of the training program. The compliance meeting by itself is not sufficient to meet the firm’s obligation for training.

This training is required for covered persons who are defined as registered representatives and their supervisors, who have direct contact with customers in the areas of sales, trading or investment banking activities.

Registered insurance agents are also subject to continuing education requirements under applicable state regulations.



Question 6-5

PROPERTIES


Suitability

As suggested by FINRA’s suitability and Know-Your-Customer guidelines, registered representatives have three suitability obligations:

1. Reasonable Basis – firms must have a reasonable basis to believe, based on adequate due diligence, that a recommendation is suitable at least for some investors;

2. Customer Specific – firms must have reasonable grounds to believe a recommendation is suitable for the specific investor; and

3. Quantitative – firms must have a reasonable basis to believe the number of recommended transactions within a certain period is not excessive (i.e., that the investor’s account is not being churned).


As part of this the registered representative should make a reasonable effort to obtain information concerning:

· The customer’s financial status

· The customer’s tax status

· The customer’s investment objectives

The evaluation should lead to the conclusion that the variable life policy being applied for is a suitable investment for a person.

Suitability


Contract Delivery

As noted in Lesson Two, variable annuity contracts provide the purchaser with a “free-look” period.

This period, generally 10 or 20 days, provides the owner an opportunity to examine the contract and, if he or she chooses, to return it for a full refund.

The free-look period does not start to run until the contract is delivered. Therefore, it is a most important practice for the registered representative to deliver the variable annuity contract promptly and to obtain a delivery receipt.


Question 6-6

PROPERTIES


Ethical Practices

The SEC and NASD, on the national level, and state insurance departments, on the state level, have devised the various compliance practices, procedures and tests to serve the public.

They are designed to assure, to the extent possible, that there will be proper disclosure of material information regarding financial services products, that the products will be suitable for people in particular circumstances, and that those with whom the buying public consults will be competent, knowledgeable and will follow good business practices.


For the registered representative, it goes beyond the effort required to satisfy the mandated compliance requirements. Conscientious registered representatives will make every effort to internalize highly ethical attitudes so that their public and private conduct will always be a positive reflection on their business and profession.

Ethical Practices


Documentation

Smart registered representatives should make a habit of meticulously documenting customer files. They keep copies of fact finding and other forms, such as asset allocations and similar items used in the sales process. They are careful to complete and have the customer sign all disclosure forms and they retain copies.

Many disclosure forms must be given to customers for their records. It is a good idea for registered representatives to maintain copies of these records in their files, as customers cannot always be counted on to maintain accurate records.


Not only is it highly ethical to keep all paperwork in order, it can also be of immense value if the customer claims, justified or not, that he or she has not been dealt with fairly. Documentation not only offers legal protection to the registered representative, it can also be effective in refreshing a customer’s memory of how things transpired should he or she remember things differently. This often heads off potential legal problems. This also helps maintain good customer relations.

Documentation


Lesson 6 Quiz

PROPERTIES






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