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Chapter 10: role of income annuities.


Income annuities are just one of the tools used to bring income to clients in retirement. Typically, annuity contracts are used by those who need and want some insurance features in addition to just the retirement income. This usually leaves out the ultra high net worth client. These high net worth people are typically not able to spend all of the income being generated from their current investments. They might use annuities only for a specific purpose. It would be money earmarked to accomplish a specific purpose that they see can be accomplished by using features available within the annuity. The fact that many advisors prefer to work with the ultra high net worth clients may explain why many advisors have not focused more on using annuities as a tool to provide income for clients in retirement.


1. In general, annuities are not taxed until distributions are made from the annuity. Thus, annuities can generally provide a long-term deferral of income tax on earnings in the annuity. Earnings from an annuity are taxable as ordinary income when includable in income (see below).

2. A deferred annuity that is held by a nonnatural person, such as a corporation or a trust, is taxed each year on income on the annuity contract (for contributions to annuity after February 28, 1986). However, an annuity held by a trust or other entity as agent for a natural person is treated as if held by a natural person.

3. If an individual transfers an annuity contract issued after April 22, 1987 for less than full and adequate consideration (i.e., a gift), the transferor is required to include in income the excess of the cash surrender value over the investment in the contract. In other words, a gift of an annuity contract will generally cause immediate recognition of all previously unrecognized income by the donor/annuity holder.

4. If distributions are received as part of an annuity stream, a portion of each annuity payment is excludable from income tax as recovery of basis until the investment in the contract is fully recovered. Annuities with an annuity starting date before 1987, can continue to use the exclusion ratio for recovery of basis even after the investment in the contract is fully recovered.

5. If payments are received as other than an annuity, payments are treated first as income subject to income tax, and then as recovery of basis excludable from income (the interest-first rule). However, investment in an annuity contract before August 14, 1982 can be recovered first (the cost recovery rule), before income is recognized.

Policy dividends (unless retained by the insurer as premiums or other consideration), cash withdrawals, loans, and partial surrenders are treated as payments received as other than an annuity. Such amounts are generally taxed under the interest-first rule or the cost recovery rule, depending on whether the investment in the annuity contract was before August 14, 1982. However, dividends received after the annuity starting date are includable in income. Also, amounts received as a lump sum on complete surrender, or as a complete refund under a guarantee, are taxed under the cost recovery rule.

6. A 10% penalty applies to the taxable portion of a premature distribution from a deferred annuity (unless allocable to investment in the contract before August 14, 1982). Major exceptions to premature distribution treatment include payments made on or after age 59 1/2, after death, or on account of disability, or as part of a series of substantially equal periodic payments.

7. An annuity can be exchanged for another annuity in a Section 1035 tax-free exchange. A life insurance contract can also be exchanged for an annuity in a Section 1035 tax-free exchange.

8. After the death of the annuity holder (or the primary annuitant where the annuity holder is not a natural person, e.g., a trust), distributions are required from the annuity. If the death occurred on or after the annuity starting date, the balance of the annuity must be distributed at least as rapidly as the method in use at death. If the death occurs before the annuity starting date, the annuity must be distributed within 5 years or, if there is a designated beneficiary and distributions start within one year of death, distributions can be made over the beneficiary's life expectancy. If the designated beneficiary is the surviving spouse of the annuity holder, the surviving spouse is treated as the annuity holder.

9. An annuity does not receive a step-up in basis at death. The beneficiary includes distributions in income under the rules described here.

10. A beneficiary can take a deduction for income tax purposes for any estate tax paid attributable to an annuity being includable in another person's estate. This estate tax deduction for income in respect of a decedent (IRD) alleviates the double taxation of amounts subject to both estate tax and income tax.

11. A loss can be recognized upon the sale or surrender of an annuity contract to the extent that investment in the contract is not fully recovered.

12. Where the annuitant has annuities grandfathered under some of the transitional rules (see above), it may be advisable to keep the investments in annuities separate. This may help preserve the grandfathered favorable tax benefit. It also may make for simpler calculations of taxable amounts. Grandfathered status is usually preserved in a Section 1035 exchange (see above).

13. All annuity contracts issued by the same company to the same annuity holder during any year (after October 21, 1988), are treated as one contract for purposes of determining the amount includable in income.

14. Different rules may apply where an annuity is purchased as part of a qualified retirement plan or IRA.

15. After 2009, a charge against the cash surrender value of an annuity issued after 1996 for a premium payment on a long-term care contract that is a rider on the annuity contract is not includable in gross income. However, the investment in the annuity contract is reduced by the charge.


1. A transfer of an interest in an annuity (e.g., irrevocable designation of beneficiary) for less than full and adequate consideration is a gift for gift tax purposes. (It may also cause recognition of income for income tax purposes, see above.)

2. If the decedent was receiving a straight life annuity which ends at death, there is nothing to include in the decedent's estate for estate tax purposes. If the decedent purchased the annuity as a gift for another and retained no interest in the annuity, the annuity is not includable in decedent's estate. Otherwise, the death value of the annuity contract is includable in the gross estate if (a) payable to the decedent's estate, or (b) if payable to a named beneficiary after decedent's death to the extent of the proportion of premiums paid by the decedent. Thus, if decedent paid all premiums, the annuity is fully includable. [The estate tax is repealed for one year for decedents dying in 2010.]

3. If the annuity holder's spouse is the beneficiary, a marital deduction is generally available for gift and estate tax purposes.

4. If the transfer is to a person two or more generations younger than the individual, the generation-skipping transfer (GST) tax is generally applicable.

[The GST tax is repealed for one year for transfers in 2010.]


Overriding Questions to Answer When Considering an Annuity Purchase

The proper application of annuitization can be determined by answering a series of questions. The overall general question is, does it accomplish the purchaser's purpose of guaranteed income for life, and compared to what?

1. Will the guarantor, the issuing insurance company, last as long as the annuitant is likely to last? This is not a question to be taken lightly. The failure of an insurance company can cause delays in payments and possible financial losses, as well as the loss of that security the annuitant sought when purchasing the annuity.

2. What amount of income will be guaranteed, and is there an alternate way of getting that income with as much security as an annuity, but without annuitization?

At some point in a person's life, generating income by working will become undesirable, insufficient, or impossible. At some time, the individual's or couple's resources for generating investment income to replace earned income must be inventoried. This involves asking all of the questions so that the advisor can document that he knows the client. Once the hard facts are known, it is time to find out the soft stuff. Does the advisor understand all of the client's hopes, fears, and wants? An open-ended question--asking what amount of ever-replaceable monthly income would make the client feel secure--can bring up a helpful and informative discussion. Once the know-your-client process is complete, there are many techniques to determine whether an income annuity is a suitable solution. The following six steps represent just one of those techniques for consideration and adaptation.

1. Inventory those dependable sources of income, such as Social Security, other government programs, pension plans, or other reliable sources providing monthly income (e.g., the monthly payments as a result of the sale of an asset).

2. Add up the total reliable long-term monthly income available to meet the client's needs found in Step 1.

3. Determine the client's wanted/needed monthly income to maintain their standard of living.

4. Determine the X factor which is the currently available monthly income short fall from the desired income. The X factor is the difference between the desired income determined in Step 3, and the available income calculated in Step 2.

5. Multiply the monthly X factor by twelve to determine the annual X factor

6. Multiply the annual X factor by twenty in order to determine how much capital generating a 5 percent X factor net annual return would be sufficient to provide an amount of income equal to the annual X factor.

Example: Assume a couple in good health, male age 70 and spouse age 68, with a good relationship and a standard of living requiring $15,000 per month.

Their reliable sources of income are Social Security providing $2,000 per month, which will reduce to $1,000 per month at the death of the first-to-die, and a $4,000 per month pension, that is a joint pension continuing 100 percent to the survivor.

The need is $15,000 per month, $6,000 per month currently is available ($2,000 + $4,000), for an X factor of $9,000 ($15,000 - $6,000) per month, or $108,000 ($9,000 x 12) per year. Assuming a conservative 5 percent return, this couple could achieve their goal fairly reasonably with $2,160,000 of capital ($108,000 / 5%).

Rules of thumb illustrated in this example:

* If the client's investable capital exceeds $2,160,000--The income annuity tools are probably not required, but certain income annuity techniques may be useful.

* If client capital is less than $2,160,000--Income annuity techniques probably suitable.

Refining the need:

The "Three Bucket" Management by Objectives approach to asset allocation is designed to provide peace of mind for the client, as well as growth of some of the assets, by having seven years of cash needs available in non-volatile interest bearing investments, with the balance invested in a diversified portfolio of equities.

Bucket 1: 2 X factor, Two years of income needs

Bucket 1 is the client's cash bucket and is composed of checking, savings, and money market funds and contains two annual X factor. In this example, this amounts to $216,000 ($108,000 x 2). At the end of year one, it would be down to $108,000, based upon the client defined X factor. At the annual review, the advisor will have an opportunity to refine the X factor calculation to the extent the balance at the end of the year is more or less than the $108,000, to adjust for future years. During periods of relatively low interest rates, some clients will object to having too much money in these low return types of investments. This helps the advisor refine the client's practical risk tolerance. However, reducing the Bucket 1 balance to less than one X factor reduces its value as a measurement device and a psychological budget discipline device. Client determined amounts pushed out of Bucket 1 would go to Bucket 2.

Bucket 2 = 5 X factor, Five years of income needs

Bucket 2 is the client's bond portfolio and could be in laddered treasuries or short and intermediate-term bond funds, or investments of comparable liquidity and low volatility, so that they are available for liquidation and client use with little chance of market losses. In this case, an intermediate-term, income tax-free municipal bond fund may be appropriate because of taxes and because the monthly income could be directed to the client's household account, thus reducing the X factor.

In the example, Bucket 2 should contain $540,000 ($108,000 x 5), five times the X factor. However, if Bucket 2 can generate a 4 percent return and the monthly interest is sent into the client's cash account in Bucket 1, the X factor can be reduced to $7,500 per month, or $90,000 per year. This changes Bucket 1 to $180,000 and Bucket 2 to $450,000 (earning 4 percent from an intermediate-term tax-free bond fund) providing $18,000 per year (or $1,500 per month) to be added to their monthly dependable income sources.

The combination of Buckets 1 and 2, containing a total of $630,000 ($180,000 + $450,000) of capital, leaves the balance of the client's investment capital with a time horizon beyond seven years and appropriate for investment in Bucket 3, a diversified portfolio of carefully managed equities.

Clients may object to this much of their capital being invested in interest bearing accounts and their objections may be saying that their risk tolerance can handle just 5 times the X factor being allocated to buckets one and two rather than 7 times the X factor.

This example assumes that the couple had an investment portfolio of $2,160,000 and that, when invested using the 3 Bucket management technique, ended up with a portfolio looking like the following.
Bucket 1 (2 X factor)  $180,000 Checking,
                       savings, money market   = 8%

Bucket 2 (5 X factor)  $450,000 Intermediate
                       term tax-free bond      = 21%

Bucket 3 (balance)     $1,530,000 Diversified
                       equity portfolio        = 71%

Note that in order for Bucket 3 to generate the needed $90,000 per year, its net after-tax, after-expenses total return needs to average about 6 percent ($90,000 / $153,000).

Although such a portfolio may appear fairly aggressive compared to the results that may be obtained from a risk tolerance questionnaire, it has been designed based upon the couple's stated objectives. The fact that they know how it works and why, and that it gives them seven years of freedom knowing that they will not have to invade their equity portfolio, puts them in a fully informed position to modify the technique to their real risk tolerance to generate their $7,500 per month income need.

Managing the Three Buckets

As the X factor is consumed over the year from Bucket 1, that X factor is replaced by the movement of capital from Bucket 2 to Bucket 1. As the balance of Bucket 2 is reduced, the advisor looks for the opportunity (up market, not down market) to move capital from Bucket 3. If equity

market conditions are negative, the replenishment of Bucket 2 is delayed until conditions improve. Figure 10.1 shows what it might look like.

The Process is Productive

Going through the process of describing the Three Bucket Strategy to clients serves a number of purposes:

1. It helps to answer the question most people have about: How do they go from living on earned income to living on capital provided income?

2. It explains the advisor's risk tolerance regarding the investment of short-term and long-term capital that clients seem to automatically modify, revealing their own risk tolerance. It seems that it is more productive, easier, and more accurate for clients to modify an existing risk tolerance rather than trying to create their own using the industry provided questionnaires.

3. It makes it easier for the clients to respond in a more meaningful way to the question on the required risk tolerance questionnaire.

4. It makes it obvious to both client and planner when some annuitization technique to reduce a client's X factor could be useful.


No matter which annuity products are being considered, it is always important to make sure that the issuing insurance company is of good quality.

Fixed Annuities For One Life

In a life contingent pure annuity, capital is invested and income payments begin within a year and continue until the annuitant's death. There is no minimum guarantee other than the regularly scheduled income payment for the life of the annuitant, as promised.

A fixed immediate, life contingent, pure annuity is likely to be suitable if:

* The client needs maximum income at minimum cost

* Inflation's effect on fixed income is not a consideration

* Everything points to a long life for the annuitant

* Liquidity is not a consideration

* It is not a medically underwritten annuity

* No dependents

A fixed immediate, life contingent, pure annuity is likely to be unsuitable if:

* Maximum income per dollar of cost is not mandatory

* Inflation's effect on fixed income is a major consideration

* Longevity confidence is lower

* Inadequate liquidity

* Dependents

Fixed Annuities For Life With Guarantees

Some sort of income continuation or refund feature after the death of the annuitant probably is appropriate the client asks, 'What if I die shortly after income begins?" The typical choices are:

1. Life and period certain (e.g. 5, 10, 15, 20 year certain). A life-contingent annuity in which the company is instructed that, in the event of the annuitant's death prior to the end of the minimum guarantee period selected, the company is to make the payments to a named beneficiary for the remainder of the guarantee period.

2. Life and refund certain. This is a life contingent annuity in which the company is instructed that, in the event of the annuitant's death prior to having received back at least the amount that was invested in the contract, it is to make the payments to a named beneficiary until an amount equal to the amount invested is paid. Sometimes the discounted present value of the future payments due may be paid in lieu of the continuing income stream, or the beneficiary could offer the guaranteed income stream to a structured settlement firm in the business of buying annuity contracts.

3. Joint and survivor life annuity. This type of annuity pays for the whole of the lives of two individuals. It continues to provide level payment until the death of the second-to-die annuitant, at which time payments terminate. There are variations of this form of payout which reduce cost or increase payments while both are living and reduce payments after the first death. There are, for example, a joint and 75 percent to the survivor annuity in which the surviving annuitant receives 75 percent of the original monthly payment. The percentage continuations after the first death typically are 100 percent, 75 percent, 66.6 percent, or 50 percent to the survivor.

4. Joint and survivor life annuity with period certain. This is an annuity which protects against the early termination of payments if both of the annuitants die early. The insurance company is instructed to continue payments until the death of the last-to-die, but with a minimum payout period of 5, 10, 15, or 20 years (depending upon the period certain that was selected).

5. Joint and survivor life annuity with refund certain. This type of annuity protects against the early termination of payments due to the death of both annuitants. The insurance company is instructed to refund the remaining balance of the deposit by continuing monthly payments to the named beneficiary after the death of both annuitants until the amount deposited is returned. If it is to be a cash refund, typically it will pay out the discounted present value of the remaining payments, or the contract could be sold on the open market to a structured settlement firm.

A fixed immediate, life contingent, annuity with post primary annuitant death guarantees is likely to be suitable if:

* The purchaser needs assurance that an inordinately short life will not cause a complete loss of capital

* Inflation's effect on fixed income is not a consideration

* Liquidity is not a consideration

* It is not a medically underwritten annuity

* Dependents are a consideration

A fixed immediate, life contingent, annuity with post primary annuitant death guarantees is likely to be unsuitable if:

* It is a medically underwritten annuity

* Inflation's effect on fixed income is a consideration

* Inadequate liquidity

* Maximum benefit of medical underwriting is desired

* No legacy wish

Fixed Annuities for Fixed Periods or Fixed Amounts

Installment payment-fixed amount and installment payment fixed period are not life contingent annuities. The potential buyer of the fixed income amount contract tells the insurance company how much she would like each annuity payment to be and for how long, and the insurance company calculates the cost. The potential buyer of an installment payment-fixed period contract tells the insurance company how much capital is available for the purchase and the desired duration of payments and the insurance company calculates the amount of each annuity payment.

A fixed immediate, non-life contingent, annuity is likely to be suitable if:

* The purchaser needs assurance that the entire capital investment plus interest will be returned during the contract period

* Inflation's effect on fixed income is not a consideration

* Liquidity is not a consideration

* Dependents are a consideration

* Tax benefits of the higher exclusion ratio is desired

A fixed immediate, life contingent, annuity with post primary annuitant death guarantees is likely to be unsuitable if:

* Inflation's effect on fixed income is a consideration

* Inadequate liquidity

Medically Underwritten Annuities

Medically underwritten immediate, life-contingent annuities may pay more than annuities that are not medically underwritten by factoring in health impairments. The insurance carrier is able to pay a higher income to those clients who are in poor health (and need as much income as possible) because of their shortened life expectancy. For example, a male age 79 could be rated as an annuitant age 87. The shortened life expectancy could, for example, increase the annuity income by as much as 40 percent. Anyone in the market for an immediate, life-contingent annuity, who has a reason to think that her longevity is likely to be less then normal, should investigate the medically underwritten market place.

Advisors that become aware of medical problems, combined with financial problems, should keep medically underwritten annuities at the top of their mind. An obvious situation would be the need for a nursing home. The loss of the ability to handle the activities of daily living and the need for long term care, if not prefinanced by buying long term care insurance, may be financed by the purchase of a medically underwritten, immediate, life-contingent annuity. Dementia, Alzheimer's, and Parkinson's can cause families great financial stress because of the unknown life expectancy. Medically underwritten annuities may offer a viable solution for this situation. A family could add up all of the assets available to pay for the cost of care and determine that there is a possibility that it could be exhausted before the patient's death. A medically underwritten annuity may be able to provide a sufficient, or at least a substantial, portion of the monthly nursing home bill.

To check the viability of the income offered, the purchaser could compare the income offered by the impaired life annuity to the income available from a fixed period, non-life contingent annuity, using the number of years of the expected life of the annuitant for the fixed period. If the fixed period annuity income exceeds the life annuity income, the family might want to take the mortality risk. If the fixed period annuity is the same or less, shifting the mortality risk to the insurance company may provide valuable peace of mind.

A medically underwritten fixed immediate, life contingent, annuity is likely to be suitable if:

* Maximum life income is desired

* The annuitant is not in good health and may have limited life expectancy

* Inflation's effect on fixed income is not a consideration

* Liquidity is not a consideration

* Dependents are not a consideration

A fixed immediate, life contingent, annuity with post primary annuitant death guarantees is likely to be unsuitable if:

* The income provided has not been compared to the income provided by a fixed period (using life expectancy) non-life contingent annuity

* Inflation's effect on fixed income is a consideration

* Inadequate liquidity

* A desire to leave a legacy exists

Fixed Indexed Annuity

The objective of an indexed immediate annuity is to address the inflation issue using a market index to provide the upside potential and guarantees to minimize downside potential. As with all annuities that incorporate features to provide increasing income over the long term, they do so at a cost. The initial payouts are likely to be less than those of a conventional, non-registered, fixed immediate annuity.

Top Ten Considerations In FIA Hierarchy Of Decision Making

1. Consumer does not want a fixed annuity because the current returns are too low.

2. Consumer does not want a variable annuity because of the possibility of loss of principal, in spite of the existence of a guaranteed interest account.

3. Consumer does want the possibility of higher interest than fixed annuities and will accept substantially less than the potential of variable annuities to avoid downside risk.

4. Consumer understands the IA structure and that the capital committed to the contract will not be needed, and will not be called upon, until after the contingent deferred sales charge period is past.

5. The maturity date, index, and crediting method are acceptable and suitable for the consumer.

6. The limits on the crediting method of participation percentage, spreads, caps, and averaging are understood, acceptable, and suitable for the consumer.

7. The minimum guarantee is understood and acceptable by the consumer as a trade-off for the potential interest that may be earned as a result of indexing.

8. The commission payable to the assisting agent is known by the consumer and is considered acceptable and well-earned.

9. The siren song of premium bonuses has been carefully evaluated and the various ways to lose the bonuses are understood and acceptable.

10. Professional help is available to help in the ongoing decision making that may be necessary.

Deferred Variable Annuity

The idea behind a variable annuity is to invest the capital sum of the annuity into a diversified investment portfolio, available within the subaccounts in the contract, anticipating that long-term appreciation will allow for increasing income to the annuitant. The risks of variable immediate annuitization are that the income can go down and no one ever can be certain that the variable annuity, tied to performance in the equity markets, will produce increased income equivalent to inflation increases. Nor do variable annuities satisfy the demand for maximum consistent monthly income that many people, who annuitize, are seeking.

Variable immediate annuitization is not without risk. However, features have been built into immediate variable annuities to minimize the chance of decreased income as a result of market downturns. Variable immediate annuities, with the right guarantee features, may be a wise choice for at least a part of the retirement capital for those who likely are to be exposed to the risk of living too long.

There are three types of guarantees added to deferred variable annuities to help people cope with their fear of losing money if the variable investment options within their annuity experience a bear market.

1. Guaranteed Death Benefits--Death of the annuitant/ owner triggers the guarantee

2. Guaranteed Annuitization Benefits--Lifetime annuitization of the capital in the deferred variable annuity triggers the guarantee

3. Guaranteed Living Benefits--Owner/annuitant elects the guarantee when the time or date of the guarantee makes it available and market conditions make it valuable to exercise. Guarantees are discussed in Chapter 9 and summarized in Figure 10.2.

Constraints On Variable Deferred Annuity Guarantees

Variable annuity guarantees are designed to lower the market risk of owning a variable annuity. As attractive as they are, they must be used within the individual annuity contract specifications in order to realize their full value if market conditions make reliance on them necessary. The following are some of the caveats and constraints that are found within the guarantee provisions.

* Variable annuities offer guarantees with the opportunity to participate in the market. Variable annuities are subject to risk, including loss of principal. Guarantees do not apply to the performance of the variable subaccounts, which will vary with market conditions.

* The guarantor of the guarantees is the insurance company alone. Money going into variable annuities is not a bank deposit, nor is it FDIC insured, or insured by any federal government agency, or any bank or savings association. The account values may go down in value. The more important the guarantee is to the contract owner, the more costly it is to the insurance company. It is only the claims paying ability of the individual insurance company that can make good on the guarantees when they are called upon.

* Insurance companies are confident in their ability to handle "the long run" and are convinced that retirees need a diversified portfolio of equities to address a long retirement period and the effect of inflation. Therefore, consumers can expect the guarantees to have constraints on where the assets may be invested in order for the guarantee to be effective. Some contracts will allow free contract owner choice, except accounts that merely earn interest and are not likely to keep up with the applicable guarantee. Some will offer a higher guarantee, such as 6 percent, for amounts invested in equity subaccounts and 3 percent for amounts invested in money market or low interest /low volatility bond subaccounts. Others may be more restrictive on the allowable investments or may require investment in specified asset allocation portfolios.

* The benefit base used to define the guarantees is not cash or an actual account value. It is used to calculate the amount available under the various guarantees. For example, the initial benefit base is the amount invested in the annuity contract. Thereafter, the base is adjusted downward for withdrawals and upward by interest roll-ups and/or market value step-ups to the level used to determine death benefits or income benefits. The calculated benefit base level may also be used to determine its cost, such as 60 basis points times the benefit base, as opposed to being calculated upon actual account value.

* The choice of one type of guarantee may make another type of guarantee unavailable

* These riders normally must be applied for with the initial application and the cost for them may not be eliminated in the future.

* When a contract provides an increasing benefit base, it can be used to increase the future income base or to make dollar-for-dollar withdrawals up to the permissible amount of the annual increase, but avoid making withdrawals exceeding the permissible amount without knowing what guarantees may be lost. Such excess withdrawals can cause the elimination of other guarantees in the contract without eliminating the ongoing cost of the lost guarantees. Carefully consider the implication of any excess withdrawals.

* If the benefit base, as opposed to the account value, is applied to purchase the guaranteed minimum lifetime income, the annuity factors used may include what are called age setbacks. For example, a 75 year old annuitant may have the benefit base applied to an annuity age factor of a 70 year old, resulting in a lower lifetime income amount.

* The lifetime minimum income guarantees, when exercised, involve annuitization thereby losing access to the lump sum.

* Ratchets that step-up the benefit base are likely to be limited in number and frequency of use (such as every five years), and may be capped at some multiple of premium paid.
Figure 10.1


           Investment     GIC          US             International
           Grade                     Equity             Equity
   2       Intermediate
 years     Term
                                  Large Cap     Small
                    5                           Cap EAFE      Emerging
                                  Value          Growth

Bucket 1        Bucket 2          Balance of Investment Portfolio
                                  Bucket 3

Consider Risk Management Tools in Annuities

Figure 10.2

Guarantee*         Protection             Protects
Feature            Provided               Against

GMDB               Death benefit          Loss of capital
Guaranteed         equals the             investment if
Minimum Death      greater of the         death occurs in
Benefit            investment             a down
                   in the contract        market
                   adjusted for
                   withdrawals on
                   a pro rata
                   basis or the
                   account value
                   at death.

GMDB plus          Compounds the          Loss of capital
interest           initial death          investment
called             benefit of the         plus interest
Roll-up or         contract at a          if death occurs
Rising Floor       stated interest        and account
                   rate such as           value is less
                   5% or 6% for           than the
                   assets held in         guaranteed
                   equity variable        death
                   investment             benefit.
                   options for a
                   limited time,
                   such as until
                   age 80 or 85.

GMDB Ratchet       Death benefit          Safeguards all
or Step-up         steps-up or            previously
                   ratchets up            reached
                   to the highest         anniversary
                   account value          date account
                   on a contract          value highs from
                   anniversary            loss creating
                   until the              a potentially
                   annuitant's            increased death
                   age 80 or 85 if        benefit if
                   living. Ratchet        death occurs
                   may occur              while account
                   annually or            values are down.
                   less frequently.
                   More often
                   is better.

GMDB plus          Compounds              Loss of capital
interest or        investment in          investment
Step-up/           the contract           plus interest
Ratchet            at a stated            if death occurs
whichever is       interest Rate,         and account value
the greater        such as 5%             is less than
                   or 6%, creating        the guaranteed
                   a death benefit        death benefit
                    for assets            and also the
                   held in equity         step-up or
                   variable investment    ratchet of the
                   options for a          death benefit
                   limited time           to the highest
                   such as until          annuity
                   the annuitant's        account value
                   age 80 or 85           on a contract
                   and also the           anniversary
                   step-up or             until the
                   ratchet of the         annuitants
                   death benefit          age 80 or 85,
                   up to the highest      if living.
                   account value
                   on a contract
                   until the
                   age 80
                   or 85,
                   if living.

GMDB + TER         The guaranteed         The TER or
                   minimum death          EER is to
                   benefit with           answer the
                   the tax                objection to
                   enhancement/           annuities that
                   earnings               the beneficiary
                   enhancement            must pay the
                   rider is               pent up
                   designed to            ordinary income
                   increase the           tax liability
                   amount of the          on the annuity
                   death benefit          gains by
                   in an amount           providing a
                   equal to 40%           cash benefit
                   of the gain            approximately
                   being                  equal to the
                   distributed            expected tax
                   at death.              liability.

Guarantee*                           Likely
Feature            Use               Cost

GMDB               Encourages        Included
Guaranteed         long term
Minimum Death      investing in
Benefit            equities
                   as a result
                   of the
                   from loss
                   of principal
                   at the
                   death of the

GMDB plus          Withdrawals       .45% of
interest           limited           benefit
called             to the            base-Note:
Roll-up or         interest          this is
Rising Floor       guaranteed        not the
                   on the            account
                   benefit base      value.
                   of a
                   of capital
                   invested plus
                   enabling and

GMDB Ratchet       Encourages        .25% of
or Step-up         equity            benefit
                   investing         base-Note:
                   while             this is
                   assuring          not the
                   beneficiary       account
                   security at       value.
                   the death
                   of the

GMDB plus          Encourages        0.65 of
interest or        equity            benefit
Step-up/           investing         base
Ratchet            while assuring
whichever is       beneficiary
the greater        security at
                   the death of
                   the annuitant
                   and as the
                   step-ups occurs
                   creates an
                   benefit base
                   from which
                   to draw the
                   5 or 6%
                   income without
                   the security
                   of the
                   beneficiary at
                   the annuitant's

GMDB + TER         Can, in effect,   0.35 of
                   provide           account
                   a life            value
                   without a

* Guarantee--All guarantees are based upon the
claims paying ability of the insurance company.
COPYRIGHT 2007 COPYRIGHT 2007 The National Underwriter Company
No portion of this article can be reproduced without the express written permission from the copyright holder.
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Title Annotation:Part 3: INSURED SOLUTIONS
Publication:Tools & Techniques of Retirement Income Planning
Date:Jan 1, 2007
Previous Article:Chapter 9: types of income generating annuities.
Next Article:Chapter 11: role of life insurance in providing living benefits.

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