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How to Get the MostKnowledge from This Course!

NAIC SUITABILITY IN

ANNUITY TRANSACTIONS MODEL

REGULATION 4 Hr COURSE

COPYRIGHT © 2011 SUCCESS CONTINUING EDUCATION 2 Corporate Plaza Drive, Suite 100 Newport Beach, CA 92660 (949) 706-9425 (A member of the Success CE family of Companies.)

© Copyright 2011 Success Continuing Education, Inc. All Rights Reserved. No part of this publication may be used or reproduced in any form or by any means, transmitted in any form or by any means, electronic or mechanical, for any purpose, without the express written permission of Success Continuing Education, Inc. This publication is designed to provide general information on the topic presented. It is sold with the understanding that the publisher is not engaged in rendering any legal or professional services. Although professionals prepared this material, it should not be used as a substitute for professional services. If legal or other professional advice is required, the services of a professional should be sought.

Table of Contents INTRODUCTION.........................................................................................................................1 

Brief History of Suitability Issues at the National Level ........................................................................ 1 NAIC White Paper Issued in 2000 ......................................................................................................... 1 Model Regulation Adopted in 2003...................................................................................................... 1 Deceptive Use of Senior Related Designations: .................................................................................... 2 NAIC Revised Model in 2006................................................................................................................. 2 NAIC Adopted Further Revisions March 2010 ...................................................................................... 3 

CHAPTER 1 ..................................................................................................................................4 

Types of Annuities and Contract Parties.................................................................................................4 Documentation.......................................................................................................................................... 4 Types of Annuities ..................................................................................................................................... 4 Classification of annuities by benefit commencement.............................................................................. 5 Immediate or Deferred.............................................................................................................................. 5 

Immediate Annuity ............................................................................................................................... 5 Deferred Annuity .................................................................................................................................. 5 Split Annuity.......................................................................................................................................... 6 

Classification of annuities based on premium payment period ................................................................ 6 Single premium annuities .......................................................................................................................... 6 Single premium deferred annuity (SPDA).................................................................................................. 6 

Single Premium Immediate Annuity (SPIA)........................................................................................... 6 Periodic Premiums ................................................................................................................................ 6 Flexible Premiums................................................................................................................................. 7 Premium Computation Factors............................................................................................................. 7 

Classification of annuities based on policy owner risk .............................................................................. 7 Variable Annuity ................................................................................................................................... 7 Fixed...................................................................................................................................................... 8 

Important Characteristics of fixed and variable annuities......................................................................... 8 Important differences between fixed and variable annuities ................................................................... 9 

Declared Rate Fixed Annuities .............................................................................................................. 9 Fixed Indexed Annuities........................................................................................................................ 9 Two‐Tiered Annuities............................................................................................................................ 9 

Parties to an Annuity Contract ................................................................................................................ 10 The Insurer.......................................................................................................................................... 10 Contract Owner................................................................................................................................... 10 Annuitant ............................................................................................................................................ 11 Beneficiary or Multiple Beneficiaries.................................................................................................. 11 Multiple Titles for One Individual ....................................................................................................... 12 Stranger Originated Annuity Transaction (STAT) ................................................................................ 12 Characteristics of a STAT..................................................................................................................... 12 Regulatory Issues and Concerns with STATs....................................................................................... 13 Insurable Interest................................................................................................................................ 13 Rebating .............................................................................................................................................. 13 Rescission............................................................................................................................................ 13 

Annuity Contract Provisions .................................................................................................................... 13 Interest Rate Crediting............................................................................................................................. 13 New Money Rate Interest Crediting Strategy.......................................................................................... 14 Portfolio Based Interest Crediting Strategy ............................................................................................. 14 Initial Interest Rate .................................................................................................................................. 15 Multi year Guaranteed Interest Annuities (MYGIA) ................................................................................ 15 Interest Rates – Guaranteed and Current ............................................................................................... 15 

Bonus Annuities .................................................................................................................................. 15 Renewal Interest Rates............................................................................................................................ 16 Minimum Guaranteed rates .................................................................................................................... 16 Issue age guidelines ................................................................................................................................. 17 

Annuity Date ....................................................................................................................................... 17 Withdrawal/Surrender Charge Waivers.............................................................................................. 17 

Nursing Home Waiver.............................................................................................................................. 17 Terminal Illness Waiver ........................................................................................................................... 18 Unemployment........................................................................................................................................ 18 Death and Disability................................................................................................................................. 18 Withdrawal Privilege ............................................................................................................................... 18 Bail‐Out.................................................................................................................................................... 18 Premium Payments.................................................................................................................................. 19 Single premium Annuity .......................................................................................................................... 19 

Periodic or Flexible Premiums ............................................................................................................ 19 Required Premiums vs Optional Premiums ........................................................................................ 19 

Surrender Charges and Penalties............................................................................................................. 19 Market Value Adjusted Annuities............................................................................................................ 20 

How the MVA Works .......................................................................................................................... 21 How the MVA is Different ................................................................................................................... 21 Risk Factor........................................................................................................................................... 21 Contract Administration Charges and Fees ........................................................................................ 22 Custodial Fees ..................................................................................................................................... 22 Spread /Asset or Margin Fee .............................................................................................................. 22 

Loading and Management Fees............................................................................................................... 22 Administrative Fees ............................................................................................................................ 22 Contract Fee........................................................................................................................................ 22 Sub‐Account Fees................................................................................................................................ 23 

Other Fees ............................................................................................................................................... 23 Withdrawal Privilege Options.................................................................................................................. 23 Withdrawal Privilege Options Qualified Annuities .................................................................................. 23 Annuitization ........................................................................................................................................... 23 Inflation During Annuitization ................................................................................................................. 24 Annuitization of a Fixed Annuity.............................................................................................................. 24 Annuitization of a Variable Annuity......................................................................................................... 24 

Fixed Account...................................................................................................................................... 24 Separate Account..................................................................................................................................... 25 Annuitization Settlement Options ........................................................................................................... 25 

Period Certain Only............................................................................................................................. 25 Life Only .............................................................................................................................................. 25 Life and Period Certain........................................................................................................................ 26 Life Only with Guaranteed Minimum Option ..................................................................................... 26 Joint and Survivor ............................................................................................................................... 26 

Death benefits ......................................................................................................................................... 26 Tradition Fixed Annuity Death Benefit................................................................................................ 26 Fixed Indexed Annuity Death Benefit ................................................................................................. 27 

Variable Annuity Death Benefit .......................................................................................................... 27 Death benefit Settlement Options .......................................................................................................... 27 

Lump Sum vs. Extended Payout.......................................................................................................... 28 Death Benefit Settlement of a Qualified Annuity ............................................................................... 28 

Principle Guarantee ................................................................................................................................. 28 Safety ....................................................................................................................................................... 28 Loan Provisions ........................................................................................................................................ 29 Additional Contract Provisions Fixed Indexed Annuities ......................................................................... 29 Fixed indexed Annuities........................................................................................................................... 29 Indexed Annuities vs. Traditional Fixed Annuities................................................................................... 30 Terminology............................................................................................................................................. 30 Participation Rate .................................................................................................................................... 30 

Participation Rate ............................................................................................................................... 30 Cap rate ................................................................................................................................................... 31 

Cap Rate or Cap on Interest Earned.................................................................................................... 31 Floor Rate ................................................................................................................................................ 31 Spread/ Margin/Asset fee........................................................................................................................ 31 Ratchet or Annual Reset .......................................................................................................................... 32 Common indexing strategies ................................................................................................................... 32 

Indexing Method................................................................................................................................. 32 Specific Term....................................................................................................................................... 32 Policy Year........................................................................................................................................... 32 Indexing Methods Calculate Percentage Change ............................................................................... 33 Fixed Interest ...................................................................................................................................... 33 Monthly Averaging.............................................................................................................................. 33 Daily Averaging ................................................................................................................................... 33 Point‐to‐Point Indexing....................................................................................................................... 34 Annual Point to Point Indexing ........................................................................................................... 35 Example............................................................................................................................................... 35 Monthly Point to Point Indexing......................................................................................................... 36 Example............................................................................................................................................... 37 Long Term Point to Point Indexing...................................................................................................... 37 High Water Mark Indexing.................................................................................................................. 37 

Combination of Indexing Methods .......................................................................................................... 38 Consumer Choice to Allocate/Reallocate Amongst Strategies ................................................................ 39 Index Strategy Performance .................................................................................................................... 39 Fluctuation of Cap and Participation Rates ............................................................................................. 39 Insurer Investing to Hedge Indexing Strategies ....................................................................................... 39 Factors Affecting Index Options Prices .................................................................................................... 40 Market Volatility ...................................................................................................................................... 40 Risk Free Rate of Return .......................................................................................................................... 40 Mid ‐ term Withdrawals .......................................................................................................................... 40 Minimum Nonforfeiture Rate Vs. Minimum Annual Credited Rate ........................................................ 41 The Minimum Nonforfeiture Rate ........................................................................................................... 41 The Minimum Annual Credited Rate ....................................................................................................... 41 Historical Perspectives............................................................................................................................. 42 Hypothetical Models................................................................................................................................ 42 Actual Returns ......................................................................................................................................... 42 Renewal Rates ......................................................................................................................................... 42 Common Indexes Used in Fixed Indexed Annuities................................................................................. 42 Standard & Poor’s 500............................................................................................................................. 43 

Varying Views...................................................................................................................................... 43 Comparison to the Dow Jones Industrial Average.............................................................................. 43 

Available Annuity Riders .......................................................................................................................... 43 Life Insurance Riders................................................................................................................................ 43 Long‐Term Care Riders ............................................................................................................................ 44 

Account Balance First LTC Approach................................................................................................... 44 Account Balance Last LTC Approach ................................................................................................... 44 Coinsurance LTC Approach ................................................................................................................. 44 Waiver of Surrender Charge Vs. LTC Rider.......................................................................................... 45 Guaranteed Minimum Withdrawal Benefit Riders ............................................................................. 45 Guaranteed Minimum Withdrawal Benefits in Variable Annuities .................................................... 45 Variations ............................................................................................................................................ 45 Investment Restrictions With GMWB................................................................................................. 46 Guaranteed Minimum Withdrawal Benefit Riders in Fixed Annuities................................................ 46 

Guaranteed Minimum Death Benefit Rider............................................................................................. 47 GMDB ‐ Basic Form ............................................................................................................................. 47 GMDB ‐ Enhanced............................................................................................................................... 48 

Chapter 1 ‐ Review Questions..............................................................................................................49 

CHAPTER 2 ............................................................................................................................... 51 

Annuity Taxation and Primary Uses of Annuities..................................................................................51 Taxation of Non‐Qualified Annuities ....................................................................................................... 51 When an Annuity is Owned by a Non‐Natural Person............................................................................. 51 Exceptions................................................................................................................................................ 51 Taxation of Withdrawals From Non‐Qualified Annuities......................................................................... 52 Total Surrender........................................................................................................................................ 52 Partial Withdrawal................................................................................................................................... 52 Aggregation Rule ..................................................................................................................................... 52 Exceptions to the Aggregation Rule......................................................................................................... 52 Taxation of Annuitization of Non‐Qualified Annuities............................................................................. 53 Taxation of Annuity Upon Death of the Owner....................................................................................... 53 If Owner Dies Prior to Annuitization........................................................................................................ 53 General Provisions ................................................................................................................................... 53 Annuitant Owned Annuities .................................................................................................................... 54 Spousal Beneficiary.................................................................................................................................. 54 Non‐Spousal Beneficiary.......................................................................................................................... 54 If Owner Dies After Annuitization............................................................................................................ 54 Taxation of Ownership Changes .............................................................................................................. 54 Exceptions to Taxation of Transfers......................................................................................................... 55 1035 Exchanges ....................................................................................................................................... 55 Life Insurance to Annuity......................................................................................................................... 55 Annuity to Annuity................................................................................................................................... 56 Partial 1035 Exchange.............................................................................................................................. 56 “One for Two” 1035................................................................................................................................. 56 Premature Withdrawal Penalty / Non‐Qualified Annuities ..................................................................... 57 Other Tax Considerations / Non Qualified Annuities .............................................................................. 57 Taxation of Qualified Annuities ............................................................................................................... 58 Contributions to Qualified Annuities ....................................................................................................... 59 The Roth IRA is an Exception ................................................................................................................... 59 Minimum Required Distributions (MRD)................................................................................................. 59 Retirement Plans Covered ....................................................................................................................... 59 Multiple Retirement Plans....................................................................................................................... 59 

IRS Penalty for Under‐Distribution .......................................................................................................... 59 Calculating the MRD ................................................................................................................................ 60 

Account Balance.................................................................................................................................. 60 Life Expectancy ................................................................................................................................... 60 

Qualified Annuity Distributions Prior to Age 59½.................................................................................... 60 Exceptions to 10% Penalty…Qualified Annuities ..................................................................................... 61 Unreimbursed Medical Expenses ............................................................................................................ 61 Medical Insurance.................................................................................................................................... 61 Disability .................................................................................................................................................. 61 Death ....................................................................................................................................................... 61 Higher Education Expenses...................................................................................................................... 62 First Home Purchase................................................................................................................................ 63 Avoidance of the Pre 59 1/2 Distribution Penalty ................................................................................... 63 Primary Uses of Annuities........................................................................................................................ 64 Tax Deferred growth vs Taxable or tax Free growth ............................................................................... 64 Tax Free Growth ...................................................................................................................................... 65 Primary Uses of Annuities........................................................................................................................ 65 

Guaranteed Lifetime Stream of Income ............................................................................................. 65 Annuitization Settlement Options ........................................................................................................... 65 

Life Only .............................................................................................................................................. 65 Advantages ......................................................................................................................................... 66 Disadvantages ..................................................................................................................................... 66 Life Only with Guaranteed Minimum Option or Refund..................................................................... 66 Advantages ......................................................................................................................................... 66 Disadvantages ..................................................................................................................................... 66 Life With Period Certain...................................................................................................................... 66 Advantages ......................................................................................................................................... 66 Disadvantages ..................................................................................................................................... 66 Joint and Survivor ............................................................................................................................... 67 Advantages ......................................................................................................................................... 67 Disadvantages ..................................................................................................................................... 67 Period Certain Only............................................................................................................................. 67 Advantages ......................................................................................................................................... 67 Disadvantages ..................................................................................................................................... 67 Long Term Retirement Accumulation................................................................................................. 68 Potential to Avoid Probate.................................................................................................................. 68 

Chapter 2 ‐ Review Questions..............................................................................................................69 

CHAPTER 3 ............................................................................................................................... 70 

NAIC ANNUITY SUITABILITY MODEL.....................................................................................................70 Section 1 Purpose .................................................................................................................................... 70 Section 2. Scope....................................................................................................................................... 70 Section 3. Authority ................................................................................................................................. 70 Section 4. Exemptions ............................................................................................................................. 71 Section 5. Definitions............................................................................................................................... 71 Section 6. Duties of Insurers and of Insurance Producers ....................................................................... 73 Section 7. Insurance Producer Training ................................................................................................... 77 Section 8. Mitigation of Responsibility .................................................................................................... 79 Section 9. [Optional] Recordkeeping ....................................................................................................... 79 Section 10. Effective Date........................................................................................................................ 80 

DETERMINING CLIENT SUITABILITY ......................................................................................................80 How Annuity Provisions Affect Consumers ............................................................................................. 80 

Personal Information .......................................................................................................................... 81 Consumer Financial Status.................................................................................................................. 81 Assets ‐ Investments and Life Insurance............................................................................................. 81 Endowments ....................................................................................................................................... 81 Annual Income.................................................................................................................................... 81 Liquid Net Worth ................................................................................................................................ 82 Liquidity Needs ................................................................................................................................... 82 Affect of IRS Early Withdrawal Penalty on Liquidity Needs ................................................................ 83 Tax Status............................................................................................................................................ 83 

Consumer’s Risk Tolerance...................................................................................................................... 83 Intended Use of Annuity ..................................................................................................................... 84 Source of Funds Used to Purchase the Annuity.................................................................................. 84 Anticipated Retirement Age ............................................................................................................... 84 Consumer’s Financial Experience........................................................................................................ 85 Financial Concerns .............................................................................................................................. 85 Future Financial Considerations.......................................................................................................... 85 Social Security Benefits ....................................................................................................................... 85 Retirement Plan Distributions............................................................................................................. 85 Investing retirement Assets ................................................................................................................ 85 Other Financial Needs......................................................................................................................... 85 Health and Medical Care Access/Cost ................................................................................................ 86 Financial Support For Family Members .............................................................................................. 86 Cross‐Selling Reverse Mortgages........................................................................................................ 86 Other Information Or Considerations Used by Producer ................................................................... 86 Access to Account Value ..................................................................................................................... 86 Required Minimum Distributions ....................................................................................................... 87 Withdrawals in Excess of the Free Amount or Full Surrender ............................................................ 87 Annuitization....................................................................................................................................... 87 

Disclosure as a Component of Suitability ................................................................................................ 87 Appropriate Sales Practices Require Disclosure ................................................................................. 87 Surrender Charge Terms..................................................................................................................... 88 

Comparison of Life Expectancy to Surrender Charge Period................................................................... 89 Annuity Tax Status and Potential Tax Penalties.................................................................................. 89 Mortality Charges and Expense Fees .................................................................................................. 89 Current Vs. Guaranteed Interest Rate ................................................................................................ 90 Investment Advisory Fees ................................................................................................................... 90 Riders or Endorsements...................................................................................................................... 90 Limitations on Interest Returns and Benefits ..................................................................................... 90 Insurance and Investment Components............................................................................................. 90 Market Risk ......................................................................................................................................... 91 

Suitability of Replacing Existing Policies .................................................................................................. 91 Annuity  Comparison When Exchanging or Replacing an Annuity...................................................... 91 

If the Consumer Currently Holds an Annuity........................................................................................... 91 Surrender Charges Existing and New Annuity .................................................................................... 91 Costs for Annuity Benefits .................................................................................................................. 91 Will the Consumer Benefit from Enhancements in the New Policy.................................................... 92 Has the Consumer had Another Annuity Replacement in the Previous Three Years ......................... 92 

Special Issues related to Sales to Seniors ................................................................................................ 92 Product Complexity............................................................................................................................. 92 legal capacity....................................................................................................................................... 93 diminished mental capacity ................................................................................................................ 93 

probability of encountering diminished mental capacity ................................................................... 93 recognizing diminished mental capacity............................................................................................. 93 indicators of diminished mental capacity ........................................................................................... 94 additional indicators ........................................................................................................................... 95 explanation of indicators .................................................................................................................... 95 Ethical and Compliance Issue Unique to the Senior Market............................................................... 96 strategies for making better decisions................................................................................................ 96 including a trusted family member..................................................................................................... 97 senior related professional designations............................................................................................ 97 The Need for Complete Recordkeeping.............................................................................................. 97 

Chapter 3 ‐ Review Questions..............................................................................................................99 

Answers to Chapter ‐ Review Questions ............................................................................................ 100 

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IInnttrroodduuccttiioonn

BRIEF HISTORY OF SUITABILITY ISSUES AT THE NATIONAL LEVEL Annuities are complex financial instruments. As annuity producers, we sell an intangible product that can not be evaluated like a tangible product. The value of what we sell is often not easy for the client to grasp, and the contracts by necessity are full of legal terms, exceptions, and contingencies. The average consumer will not fully understand an annuity contract, so they must trust the person selling them the product. Most often this trust is well deserved, but this does create an environment where the consumer can be misled and enter into a transaction that is not in their best interest. Over the past several years, Insurance Commissioners have been closely monitoring complaints from consumers regarding annuity sales. While the total number of complaints remains low relative to other lines of insurance, they show a troubling trend over time. In the states that have reported data on annuity sales to the National Association of Insurance Commissioners (NAIC), there was a marked increase in the number of complaints in the categories of suitability, agent handling, and misrepresentation over the period from 2004 thru 2007 (latest data). The total number of complaints reported in these categories rose from approximately 1400 in 2004 to more than 2300 in 2006. The proportion of these complaints attributed to suitability issues has also increased each year, from just over 10% of that total in 2005, to more than 18% in 2007. Each and every complaint is reviewed and investigated by the respective state Department of Insurance. Since 2004, more than 75% of the annuity complaints reported by state regulators to the NAIC have been resolved in favor of the consumer.

NAIC WHITE PAPER ISSUED IN 2000 In light of the recent trends in complaints for annuity sales, the NAIC adopted a white paper in 2000 that called for the development of suitability standards for non-registered annuity products similar to the standards that existed under the Securities and Exchange Commission (SEC) for registered products. The result of that white paper was a working group under the NAIC Life Insurance and Annuities Committee that drafted a model regulation, setting suitability standards for all life insurance and annuity products.

MODEL REGULATION ADOPTED IN 2003 The committee decided to focus first on the area that had been identified as subject to the greatest abuse: the inappropriate sales of annuities to persons over the age of 65.

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The resulting Senior Protection in Annuity Transactions Model Regulation (“Suitability Model”) was adopted by the NAIC in 2003. This new model was another tool that regulators could use to protect consumers from inappropriate sales practices in addition to the previous NAIC Annuity Disclosure Model Regulation.

DECEPTIVE USE OF SENIOR RELATED DESIGNATIONS: A recent series of news articles in the New York Times and the Wall Street Journal have pointed to problems with the use of professional designations that imply expertise in providing investment advice to senior citizens, such as “Certified Senior Adviser,” “Certified Retirement Financial Adviser,” “Chartered Senior Financial Planner” and “Certified Financial Gerontologist.” Some claim that those designations involve little actual training regarding the needs of this vulnerable population. It appears from these news articles that these designations, which are granted by for-profit entities, serve more as marketing tools than as actual evidence of education or professional development. Most of the problems that have been reported against persons using these credentials have dealt with the sale of unsuitable annuities to senior citizens. (From testimony of Sandy Praeger, Kansas Insurance Commissioner and NAIC President Elect before the Senate Select Committee on Aging, September 5, 2007) While annuity suitability laws deal with the suitability of the sale of annuities to individuals of all ages, it is the senior citizen that is most often targeted for annuity sales. There are multiple reasons that senior consumers are the main focus of annuity sales efforts, but the main reason is that they have accumulated more funds than younger individuals and are often motivated to settle their financial matters as they enter their golden years. As our population in the United States ages, senior sales issues will become more prevalent and subject to additional regulations. Several states have passed laws prohibiting the use of professional designations with the words “Senior,” or “Retirement,” or similar wording that implies special qualifications in the senior market, unless the entity offering the designation can demonstrate that successful candidates possess additional training or education. It should be noted that there are a number of well established industry designations with rigorous training and continuing education requirements which are viewed as valid designations by regulators and the industry as a whole.

NAIC REVISED MODEL IN 2006 Purchasing life and annuity products is often a complicated and confusing process for consumers of all ages, and regulators felt that the protections of the Suitability Model should not be limited to seniors. Addressing this issue in 2006, the NAIC membership adopted revisions to the Suitability Model to have its requirements apply to all consumers regardless of age.

3

NAIC ADOPTED FURTHER REVISIONS MARCH 2010 In March of 2010, the NAIC voted to adopt revisions to The NAIC Suitability in Annuity Transactions Model Regulation. Several states have already adopted the revised Model Regulation and more are expected to adopt the Model Regulation within the next year. In order for the producer to have a clear understanding of the direction of regulation in annuity sales, we will review the NAIC Model Regulation as part of this course. As each state adopts the regulation they are likely to make changes to contemporize the Model Regulation to local law and circumstance, so it is important for the producer to realize that the Model Regulation is not a binding law. This course examines fixed, variable, bond index, single premium, equity-indexed, tax-sheltered, and market-adjusted annuities - all of which are available in the marketplace. This course also highlights distribution opportunities and tax consequences that are a fundamental component of annuity accumulation programs. Chapter review questions are included at the end of each chapter to enhance retention of key elements and confirm the student’s mastery of course content. An answer key is included at the end of the course. Whether the student is a new agent or a veteran, new insights will be gained into the world of annuities. Current annuity information and regulations provided in this course will enable the student to brush up on knowledge already acquired. Annuities have been available in the United States for more than 100 years; in other countries, they have been available for several hundred years. Although annuities are sold only by the insurance industry (i.e., insurance agencies, brokerage firms, investment advisors, financial planners, banks, and savings and loans institutions), they are not life insurance or insurance coverage. Contractual guarantees contained in annuities depend upon the type of annuity purchased.

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CChhaapptteerr 11 Types of Annuities and Contract Parties Although a wide range of annuities exists, each separate type of annuity contains various options and features. All annuities can be divided into two basic types: fixed or variable. If a set rate of return is desired, the contract owner will most likely choose a fixed annuity. A traditional fixed annuity guarantees that deposits will accumulate at a minimum specified rate of interest. The insurance company, however, may pay a higher rate of interest if its investment experience is greater than the minimum interest guarantee. If a conservative to aggressive investment is desired, the contract owner may choose a variable annuity. With a variable annuity, the contract owner can choose among a variety of separate accounts. Many variable annuities also include, for a cost, guarantees normally associated with a fixed annuity. DOCUMENTATION

The purchase of an annuity is structured similar to the purchase of a certificate of deposit (CD) or mutual fund: via an annuity application or agreement between the investor (contract owner) and the financial or insurance organization (insurer). The contract owner must complete an application and submit it to the insurer, furnishing the following information:

• Name • Current address • Social security number of the contract owner • Name, social security number, address, gender, and date of birth of the

annuitant • Investment options desired • Source of funds to be deposited • Signature of the contract owner • Signature of the annuitant

In the near future health questions may also be added to some annuity applications due to a recent trend in Stranger Originated Annuity Transactions (more later). TYPES OF ANNUITIES

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CLASSIFICATION OF ANNUITIES BY BENEFIT COMMENCEMENT

IMMEDIATE OR DEFERRED

IMMEDIATE ANNUITY An immediate annuity begins making periodic payments right after the policy is issued. (within one year after purchase). It is usually issued in exchange for a single lump-sum premium that provides a guaranteed fixed-payment amount. These payments may be made monthly, quarterly, semi-annually, or annually and are based on the annuitant’s life expectancy or that of the annuitant and his or her spouse. In some cases an immediate annuity can begin providing income as few as 31 days after purchase of the annuity. For example, if the contract calls for monthly payments, the payments will begin one month after the date of the annuity purchase. Immediate annuities are specifically designed for those individuals who need to receive a specific amount of money each month. Immediate annuities can be used as the sole source of income or as an income supplement. The amount of the check the annuitant receives is in direct relationship to the total annuity investment. It is important to remember that if the insurance company begins paying the annuitant shortly after the purchase of the contract, the immediate annuity must have been paid by a single payment, or all premiums must be received within a 30 to 45 day period immediately after the first premium is received.

DEFERRED ANNUITY A deferred annuity is one that defers, or delays, making payments until a later date. It delays an annuitant’s income stream and accumulates interest while delaying taxation of earnings until withdrawal. Deferred annuities are often purchased during a consumer’s working years in anticipation of the need for retirement income. Most deferred annuities provide a great deal of flexibility surrounding the timing and amounts of payout benefits. A deferred annuity offers growth and flexibility over either a long or short period of time and can be purchased with a single premium, periodic premiums, or flexible premiums. The annuitant of a deferred annuity can elect to receive a certain dollar amount of income each year and can direct how the balance is to be reinvested. This deferral process gives the annuitant the flexibility of automatic reinvesting, withdrawal of a portion of the principal, or termination of the investment. NOTE: All annuities grow tax-deferred. In the context of the above discussion the word deferred refers to the deferral of the commencement of benefit payment versus the tax-deferred treatment of internal growth that all annuities receive.

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SPLIT ANNUITY

A split annuity is actually two or more (usually two) annuities strategically employed. One annuity provides a monthly income for a defined time period while the other restores the original principal invested over the same period of time.

The strategy of a split annuity uses a single-premium deferred annuity and a single-premium immediate annuity. The immediate annuity pays a predetermined amount of income over the chosen time period. The single-premium deferred annuity is left to grow, with the goal being that at the end of the chosen income period the deferred annuity will have grown to equal the amount originally invested in both annuities.

CLASSIFICATION OF ANNUITIES BASED ON PREMIUM PAYMENT PERIOD

SINGLE-PREMIUM ANNUITIES

Single-premium annuities are purchased with a lump sum and payouts begin either immediately or at some point in the future. This is the most common type of immediate annuity. Single-premium annuities involve the payment of a single premium, and the insurance company promises to pay the annuitant an amount over a certain period (monthly, quarterly, semi-annually, or annually).

SINGLE-PREMIUM DEFERRED ANNUITY (SPDA)

A single-premium deferred annuity (SPDA) is an annuity that is purchased with only one premium payment. Usually, that single premium is relatively large--but it does not have to be. Insurance companies require minimum premiums for this type of contract and they may range from a few thousand dollars to much larger amounts. The money placed in an SPDA is left to accumulate for the future. When annuitant desires to have a stream of income, he or she annuitizes the contract.

SINGLE-PREMIUM IMMEDIATE ANNUITY (SPIA) A single-premium immediate annuity (SPIA) is an annuity that is also purchased with only one premium payment. Like the SPDA’s premium, it is also relatively large and subject to certain minimum amounts. An SPIA differs from an SPDA because the annuitant chooses to receive an income stream immediately after making the annuity purchase.

PERIODIC PREMIUMS

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The second type of premium payment is periodic. In these annuities, the premiums are paid in periodic payments over a number of years prior to the date on which the annuity payout begins. The premiums can be paid monthly, quarterly, semi-annually, or annually.

FLEXIBLE PREMIUMS The final type of premium payment is a flexible-premium annuity. In these annuities, the annuity owner has the option to vary the amount of each premium payment, so long as they fall between minimum and maximum amounts.

PREMIUM COMPUTATION FACTORS Insurance companies use multiple factors in determining annuity premiums:

• The annuitant’s age. • Gender—because women live longer than men, women receive more

income payments than men of the same age (except for gender neutral rates if required).

• The assumed interest rate. • The amount of periodic income. • Contractual guarantees. • Insurance company operating expenses, or “loads.”

CLASSIFICATION OF ANNUITIES BASED ON POLICY OWNER RISK

Because fixed annuities guarantee fixed, monthly payments, those payments will vary and will depend upon the performance of the investment options chosen by the insurer. A variable annuity offers a wider range of investment options than a fixed annuity, and the contract owner chooses those investment options. In a variable annuity the value of the investments chosen by the contract owner varies in accordance with the total investment performance of the contract. The fluctuation of the cash value and monthly income is the main difference between variable and fixed annuities. Typically, variable annuities allow equity investments and fixed investments, whereas a fixed annuity offers only fixed investments.

VARIABLE ANNUITY A variable annuity fluctuates in value according to the performance of its underlying investments (separate or sub accounts), which are held by the company in a separate account outside their general accounts. All variable annuities must be registered with the Securities and Exchange Commission (SEC). We will cover suitability requirements specific to variable annuities later in the text under our FINRA discussion. Premiums paid for variable annuities are directed by the annuity owner into separate accounts (known as sub-accounts) where the company is permitted more investment

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freedom than with its general funds. Separate accounts are generally invested in common stocks and other securities that are expected to increase in value as prices increase. The purpose of a variable annuity is to provide an annuity income, which will maintain its purchasing power in inflationary times. Unless the owner of a variable annuity purchases additional riders (living benefits), they have no guarantee of safety of principal and bear all of the investment risk associated with their separate account choices.

FIXED A fixed annuity does not fluctuate in value. The underlying investments are owned by the insurance company as part of its general account. The insurance company guarantees the value of each in-force annuity policy that is backed by its general assets. Every fixed annuity policy contains an underlying guaranteed minimum nonforfeiture interest rate. The minimum interest rate during the accumulation period may be different than the minimum interest rate during the payout period. In addition to the guaranteed underlying nonforfeiture interest rate, the annuity company usually declares a current interest rate that is higher than the minimum nonforfeiture rate, and it is normally guaranteed for a period of time, generally one year. At the end of this period, the insurer will declare a new current credited rate. Premiums paid for fixed annuities are invested with the insurance company’s general funds, chiefly in fixed-income types of securities, with the ultimate purpose of providing a level annuity income. Although the fixed annuity affords the contract owner a guaranteed rate of return, that rate is dependent upon the length of time the funds will be invested. The most common maturity periods for annuities are one, three and five years; the longer the commitment, the higher the guaranteed rate of return for the contracted period. In a fixed annuity, the contract owner is protected against rising or declining interest rates, stock market gains or losses, and insurance company profits or losses through guarantees, the safety of principal, and knowing the exact amount of interest the annuity investment will earn. These guarantees and assurances are appealing to the conservative investor. The moderate to aggressive investor can utilize this type of annuity as a stabilizing factor in his overall portfolio. The guarantee a fixed annuity offers, when used along with other investments (i.e., real estate, stocks, bonds, gold, mutual funds), can help a diversified investor feel secure in his overall investment program. IMPORTANT CHARACTERISTICS OF FIXED AND VARIABLE ANNUITIES

Some important shared characteristics of fixed and variable annuities are: • Retirement income is the primary purpose. • Purchase methods.

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• Annuity options. • Accumulation and annuity periods. • Partial surrender provisions. • The guarantee of expense and mortality.

IMPORTANT DIFFERENCES BETWEEN FIXED AND VARIABLE ANNUITIES

Some important differences between fixed and variable annuities are: • There is no guarantee of the principal, interest, or the amount of

payment in variable annuities. • The annuitant bears investment risks in variable annuities. • Variable annuities are regulated by the state and federal government.

DECLARED-RATE FIXED ANNUITIES Fixed annuities pay an interest rate that is guaranteed for one or more years and have surrender charges that typically decrease over one or more years. A fixed annuity refers to the interest rate paid by the insurance company on the funds deposited into the annuity. When an individual purchases a fixed annuity, he or she knows the current and guaranteed interest rates; he or she also knows that fixed rates of interest will be earned on the contract values as long as the contract remains in place. Fixed annuities offer security because the rate of return is certain and declared in advance. The risk of performance falls on the company issuing the annuity and the annuitant does not have to assume responsibility for investing the money. In addition, the fixed nature of these annuities applies to the amount of the benefit to be paid out during the annuitization period, as well.

FIXED INDEXED ANNUITIES Fixed indexed annuities are fixed annuities where the current credited interest rate is determined based on a formula applied to an external financial index such as the Standard and Poors 500 (S&P 500). Within the limits of availability in the contract, the annuity owner determines which index (or multiple indexes) are used to determine the current credited interest.

TWO-TIERED ANNUITIES A Two-Tiered Annuity is a product containing three different values. These values are tier-one value, the surrender value, and the tier-two value. The tier-one value is the premium accumulated with interest earnings, just like a regular fixed annuity. This value is available to clients who decide to surrender their contracts for lump-sum after the surrender charge period.

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The second value is the surrender value, which is the tier-one value less any applicable surrender charge. The surrender value is available to clients who decide to surrender their contracts for lump-sum during the surrender charge period. The third value is the tier-two value, which provides a benefit that is typically higher than the tier-one value; it is only available to clients who annuitize their contracts. Tier-two benefits may include higher interest rates, higher index crediting, bonuses, or other benefits that encourage the client to annuitize, thereby leaving assets longer with the insurance company. In most two-tier annuity products, clients must wait a certain period of time before they can access these higher tier-two values. Why would a client buy a two-tier product? Two-tier products can be valuable in several ways. If clients have a need for a lifetime stream of income, they may receive higher lifetime benefits under a two-tier product than under a regular deferred or immediate annuity that is annuitized. Secondly, due to the design and pricing of two-tier products, tier-one credited rates could be higher than a non-tiered deferred annuity as a result of better participation rates, caps, or fees. What are some of the disadvantages of two-tier products? These products may not be suitable for clients who have short-term liquidity needs or a desire to pass on lump-sum benefits to their heirs. In addition, clients usually have to wait a specified period of time before receiving the higher tier-two values. Keep in mind that annuitization is required to receive those values, which spreads the benefits out over a longer period of time. Usually the annuitization must occur over at least a 10 year period. Insurance agents should make very clear to clients who are considering a two-tiered annuity the different values, how to access their values, and the restrictions or consequences when they do. Clients should assess their needs and examine all aspects of an annuity product before determining if a particular annuity design fits their needs and financial goals. PARTIES TO AN ANNUITY CONTRACT

The participating parties in the annuity contract are the insurer (insurance company or financial organization), the contract owner, the annuitant, and the beneficiary.

THE INSURER Although annuities are not life insurance contracts, many reasons exist that permit life insurance and annuity contracts to work hand-in-hand to offer the contract owner the ultimate in financial protection. An annuity guarantees an income, no matter how long the annuitant lives. While life insurance provides protection against dying too soon, annuities provide protection against living too long.

CONTRACT OWNER

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It is the contract owner’s right to choose and manage the investment options: • Add additional funds. • Withdraw any portion of the funds already deposited. • Change contract parties (i.e., annuitant, contingent annuitant,

contingent owner, beneficiary). • Terminate the annuity.

The contract owner does not have to be one individual, but must be a legal adult. If the contract owner is a minor, the policy must include the minor’s custodian or legal guardian as co-owner. The contract owner can also be a couple, a partnership, a trust, or even a corporation.

ANNUITANT Any person whom the contract owner chooses to name as the annuitant (i.e., self, family member, etc.) must be currently living and must meet the insurance company’s age restrictions for issuing the annuity. Generally, the annuitant must be younger than 95 years old on the date of application, although the precise requirements will vary by insurance company. The contract owner has the option to change the annuitant at any time, but most annuities require that the new annuitant was alive when the original contract was executed. In the majority of cases, the contract owner and the annuitant are the same person. For purposes of this course, unless specified otherwise, all discussion and examples will assume the contract owner and annuitant to be the same individual. An annuitant is the equivalent of the insured in a life insurance policy; however, the annuitant cannot:

• Control the contract. • Make withdrawals. • Make deposits. • Change the parties to the contract. • Terminate the contract.

A life insurance policy names an insured party and remains in effect until:

• The owner terminates the contract. • The owner fails to make premium payments when due. • The insured dies.

An annuity contract remains in effect until:

• The contract owner makes a change. • The annuitant dies,

BENEFICIARY OR MULTIPLE BENEFICIARIES

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The beneficiary(ies) named on the annuity contract receive the proceeds of the annuity upon the death of the annuitant. The beneficiary(ies) are designated by the contract owner and may be family members, one or more individuals, a trust, a corporation, or a partnership. The annuity contract permits multiple beneficiary designations--at the direction of the contract owner. For example, a beneficiary designation may be listed so that the spouse of the contract owner will receive 70% of the annuity contract value, and the contract owner’s three children will each receive 10% of the contract value. The contract owner retains complete control over the annuity contract during his or her lifetime by naming him or herself as contract owner and/or annuitant, and naming one or more parties as beneficiary(ies). Most insurers stipulate minimum and maximum age limits for the both owner and the annuitant. Since the beneficiary is the party receiving the proceeds of the annuity upon the death of the annuitant, and the contract is terminated at the payout, no age limits exist pertaining to the beneficiary. The minimum and maximum ages are used to determine the minimum age at which an annuity contract may be issued and the maximum age that the annuity contract may be issued. The minimum age is typically 0 but, in some cases, it is 18. Maximum age depends on the insurer and usually ranges between 60 and 90; the majority of insurers stipulate maximum ages as being 85 or 90.

MULTIPLE TITLES FOR ONE INDIVIDUAL The contract owner has the option of assigning multiple titles to himself or herself, the annuitant, or the beneficiary. If the contract owner designates a living trust or a corporation as beneficiary, the corporation or trust may only be the contract owner and/or beneficiary. The annuitant must be a living individual meeting the insurer's age restrictions.

STRANGER ORIGINATED ANNUITY TRANSACTION (STAT)

A Stranger Originated Annuity Transaction is a transaction initiated for the benefit of an investor who has no relation to the person upon whose life the annuity is based, and once the transaction is completed, neither the annuitant nor his or her beneficiaries will have any further interest in the annuity benefits. These transactions have occurred in several states and some of these transactions are being litigated.

CHARACTERISTICS OF A STAT

• Single premium annuity with death benefit if annuitant dies before annuitization date.

• Owner has no clear insurable interest in annuitant. • Annuitant is an unrelated terminally ill person (often recruited through a

hospice). • Annuity application does not ask health questions.

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• Originating transaction is small to fly under radar and more funds are added later.

• Multiple annuities issued on same day with different companies so annuitant not on more than one annuity with a single insurer.

• Annuitant paid a fee for participating and has no other interest in the annuity or benefits.

• Annuitant often unclear that they are participating in an annuity (often told they are helping a charity).

REGULATORY ISSUES AND CONCERNS WITH STATS

INSURABLE INTEREST

Annuity owner is a stranger to the annuitant and has no insurable interest. Often the annuitant is picked based on their diminished health or terminal illness.

REBATING Annuitant is paid a fee “as an inducement” to participate in the annuity contract. This could be a violation of rebating or commission sharing laws in most states.

RESCISSION Do the insurers have a rescission right if the annuity owner had no insurable interest in the annuitant? So far the main concern for the annuity industry is with variable annuities that offer a guaranteed living benefit (GLB) rider. Currently the National Association of Insurance Commissioners (NAIC) and several state regulatory offices are reviewing the issue of Stranger Originated Annuity Transactions to determine if a regulatory response is indicated.

ANNUITY CONTRACT PROVISIONS

INTEREST RATE CREDITING

Regulations require that annuity companies invest most of their portfolios in a conservative manner. With this in mind, insurers don’t have a large portion of their general account invested in equities or real estate. Most insurers invest the majority of these funds in bonds. In building their bond portfolios, insurers have flexibility in determining the mixture of bond ratings (quality) and average maturity. A bond’s rating can affect the yield of the

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bond. The higher a bond’s rating the lower the yield. The maturity date of the bond can also affect yield: The longer the maturity date on a bond the higher the yield. The company will invest the annuity premiums in one or more bond portfolios, but the return is only loosely related to the performance of the bonds. The actual return to the investor may be more or less than the performance of the underlying portfolio, especially in the short term. NEW MONEY RATE INTEREST CREDITING STRATEGY

The new money interest crediting strategy is also called bucket crediting strategy. In utilizing the new money interest crediting strategy, an insurer places the incoming annuity premium deposits during a given time period (the time the current bucket is open) into a segregated portfolio (bucket). Incoming premiums are directed into the same bucket as long as interest rates remain relatively stable. Once a significant change in interest rates occurs the insurer closes the current bucket which means no new premiums will be accepted into the bucket. A new bucket is now opened to accept future incoming premiums. In a period of widely fluctuating interest rates, an insurer may open and close a bucket in as short a period as one week. At renewal time the insurer evaluates each bucket to determine the renewal rate. The cash flows from the underlying investments, reinvestment of the undistributed cash flows, and the market value of the investment portfolio within the bucket and several other business-related metrics affect the renewal rate. The renewal rate for each bucket applies only to contracts issued while that particular bucket was open. PORTFOLIO-BASED INTEREST CREDITING STRATEGY

The portfolio-based interest crediting strategy is much simpler than the new money strategy. One large portfolio is created and is not segregated as in the new money strategy. All incoming annuity premiums are directed to this one portfolio. The return of that portfolio is used to establish the interest rate for all annuity owners who buy that particular annuity. At renewal time the insurer evaluates the portfolio to determine the renewal rate for all who own that annuity. Most insurers using the portfolio-based interest crediting strategy apply one interest rate to all annuity owners within the portfolio. Some insurers using the portfolio-based interest crediting strategy will credit interest on a calendar-year basis. For example, let's say that an insurer using the portfolio-based interest crediting strategy declares the rate for the annuity each year on January 10. Regardless of when during the next year a consumer buys that annuity, they will earn that declared interest rate until next January 10.

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There are many proponents and detractors for each of the above interest crediting strategies. INITIAL INTEREST RATE

Some insurance companies offer initial interest rates that are above market (or actual portfolio return) for a limited period of time, typically one year.

At the end of the first year, the initial guarantee expires and the annuity begins to be credited with "current credited" rate. This current credited rate is whatever the insurance company decides to pay, limited only by a "guaranteed" rate contained in the contract.

MULTI-YEAR GUARANTEED INTEREST ANNUITIES (MYGIA)

This category of annuities contains products that guarantee interest for the same number of years during which surrender charges exist. For example, annuity products that have a 5-year guaranteed interest rate and a 5-year surrender charge are examples of multi-year guaranteed interest rate annuities. Often the term CD-type annuities is applied to these annuities. INTEREST RATES – GUARANTEED AND CURRENT

In general, insurance companies offer two interest rates in fixed annuities. The guaranteed rate is the minimum rate of interest the insurance company will credit on all funds in the annuity, regardless of interest rates available in the marketplace. The current rate is a rate of interest that the insurance company credits based on the investment return within its general accounts (discussed above). The current rate is generally revised once a year but can be adjusted more frequently, depending upon the annuity.

BONUS ANNUITIES First Year Bonus The most common type of annuity bonus is a First Year Bonus, which offers a higher first-year interest rate, usually guaranteed for one year. The "base rate" is the interest rate the company projects it will pay in the second year and thereafter, but this rate is NOT guaranteed in most cases. The difference between the actual rate in the first year and the projected base rate for subsequent years is the bonus rate. Quite often, the renewal rate a company declares on each contract anniversary date beginning in the second year is different than the projected base rate. The first year bonus is used as an inducement to move large blocks of money into an annuity. Premium Bonus Some annuity contracts will offer a premium bonus instead of a first year bonus. For an individual who doesn’t have a large sum of money to deposit into an annuity, the motivation is greater to elect a smaller “bonus” on all premiums paid into the annuity for

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a number of years. Some annuity contracts offer a premium bonus as high as two percent for the first five years of premium payments into the contract. Annuitization Bonus Some annuities offer an annuitization bonus to encourage annuitization. While the terms of annuitization bonuses vary from one annuity to another they do share common characteristics such as:

• A requirement for a minimum holding period before bonus is available. • A set amount (usually expressed as a percent of the contract value) is added to the

annuity value when annuitized. Examples: 2% added after the 5th contract year, OR 1% added per contract year up to a maximum of 10%).

• Minimum annuitization time period required (usually at least 5 year period certain…some require lifetime annuitization).

Vesting of Bonus amounts The bonus amounts calculated based on the specific bonus feature will be paid in addition to the current rate; it may or may not be forfeited, depending upon the contract provisions. In many cases, a bonus rate of interest is forfeited if the annuitant withdraws funds prior to the end of the surrender period or earlier than a stated policy year of the contract. Generally, the larger the bonus the more restrictive the surrender terms on the bonus amounts. Some annuity contracts stipulate that the bonus amounts are forfeited if the annuitant makes withdrawals without annuitizing the contract. Other contracts begin a multi-year vesting period after the traditional surrender period has expired. For example, if the annuity has a seven-year surrender period, the bonus amounts may vest at 33 1/3 percent per year in years eight through ten. The multi-year vesting schedule is designed to increase persistency. RENEWAL INTEREST RATES

The renewal interest rate is credited to an annuity in the years following the initial rate and will be calculated and declared using the interest rate crediting strategies discussed earlier. MINIMUM GUARANTEED RATES

The minimum interest rate that is guaranteed for the life of the annuity is also known as the nonforfeiture rate. State departments of insurance mandate that annuities provide a lifetime guaranteed interest rate (which can vary between 1.5% and 3%). An insurer may guarantee a rate higher than the nonforfeiture rate but they are not required to do so.

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ISSUE AGE GUIDELINES

Most insurance companies allow annuities to be purchased by individuals (both contract owner and annuitant) until they are age 90. Minimum issue age is often set at age 0. However, other insurance companies will set the maximum age for contract owners and annuitants to be 80 or 85. Some annuities will have shorter surrender charge periods for issues ages over a certain age (usually age 70). Many annuity companies will offer multiple annuity products with some products not available for clients over a certain age. The minimum and maximum issue ages are usually expressed as the age of the annuitant, but many insurers will specify the minimum or maximum issue age applies to the owner or annuitant.

ANNUITY DATE The annuity date is the date at which the annuitant begins to receive annuity payments. This date is the earlier of the optional date elected by the annuitant or the maturity date. The maturity date is the latest date the annuitant may defer annuity payout options and is stated in the contract. Many contracts stipulate that the annuitant may change the maturity date; however, the new maturity date may be the last day of the term but may be no later than the maximum age stated in the contract. The maturity date is often misunderstood. It is typically the last date by which the annuitant must take receipt of the proceeds -and not the first date on which proceeds may be withdrawn without surrender penalties. The IRS does not require age limits when benefits are paid but most insurance companies establish annuitization limits at age 80 to 85; others establish the maximum age at 100. It is important for an agent to know what age maximums apply to both contract owners and annuitants, since differing age limits will affect a variety of features of an annuity.

WITHDRAWAL/SURRENDER CHARGE WAIVERS NURSING HOME WAIVER

Some insurance companies include a special feature to provide additional liquidity without surrender charges. Their annuity contracts offer a waiver of the contract’s surrender charges or withdrawal penalties in the event the annuitant is either hospitalized or confined to a nursing home for a certain period of time, such as 30 days or longer. This provision allows the contract owner to withdraw funds from the annuity to pay expenses or replace lost income associated with the hospitalization or confinement. Other annuity contracts allow medically-related surrenders that are not subject to surrender charges. Generally, there is a requirement that the annuitant be confined in a medical care facility for a certain period of time or be diagnosed with a terminal illness. Some insurers also permit the confinement of a spouse of the annuitant in a nursing home to trigger the waiver. The IRS applies a 10% penalty (premature distribution penalty) to withdrawals from annuities that are made before annuitants reach age 59 ½. This penalty does not apply if

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the annuity owner qualifies as being disabled, disability here being defined by the Internal Revenue Code (IRC). The IRC definition may differ from the definition used in the annuity contract. For purposes of the 10% premature distribution penalty tax, IRC defines disabled as follows: “being unable to engage in any substantially gainful activity by reason of any medically determinable physical or mental impairment which can be expected to result in death or to be of long-continued and indefinite duration.” TERMINAL ILLNESS WAIVER

Some annuities will waive all or part of a surrender charge if the annuitant is terminally ill. Terminal illness usually requires a life expectancy of 6 month or less. Some insurers also permit the terminal illness of a spouse of the annuitant to trigger the waiver. UNEMPLOYMENT

A small portion of annuities offer an unemployment surrender charge waiver. When this waiver is available, it always specifies that the annuitant be under age 65 at time of issue and/or unemployment. Some unemployment waivers require that you have been employed fulltime for a certain number of years (usually 2 or more) prior to issue date in order to benefit from the waiver. In addition, the unemployment waiver will specify a minimum period of unemployment such as 30 or 60 consecutive days before you can make a withdrawal free of the surrender charge. DEATH AND DISABILITY

Many insurance companies will waive surrender charges if the annuitant dies or becomes disabled. It should be noted that a number of annuities will waive the surrender charge upon death only if the beneficiary draws the funds out over at least a five year period. WITHDRAWAL PRIVILEGE

In addition to the partial and full surrenders previously discussed, annuitants frequently need to access funds for a variety of reasons. Many annuities allow annuitants to withdraw up to 10% of their account value each year without applying surrender charges. Similarly, other contracts allow for withdrawals of the interest in the account, or 10% of the contract value, whichever is greater. Still other contracts allow the 10% withdrawal amounts to accumulate each year to allow for accumulated withdrawals of 20%, 30%, 40%, etc. as time goes by. BAIL-OUT

Some fixed annuities may have a bail-out provision (sometimes called an escape clause). This feature allows the contract owner to cash in the contract without surrender charges if the interest rate credited to the annuity falls below a certain predetermined level. An example involves a provision with the bail-out rate specified to be 1% below the current credited rate. In this instance, if the declared interest rate is more than 1% below the current interest rate, the contract owner could surrender the annuity and not pay any

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surrender charges. This provision provides peace of mind for the contract owner who wants to move money in times that experience dramatically falling interest rates but would not otherwise be able to do so. PREMIUM PAYMENTS

As stated earlier in the text, all annuities can be classified as either single-premium or flexible-premium annuities. SINGLE PREMIUM ANNUITY

A single-premium annuity can actually involve multiple premiums that are all paid within the first 60 days of the policy. If a consumer is consolidating funds from several sources, it is unlikely that all of the funds will be available on the same day, so a single premium annuity will allow several premiums as long as they are all made within a short period of time.

PERIODIC OR FLEXIBLE PREMIUMS Another type of premium is a periodic premium, or flexible premium. With this premium option, the annuity owner can establish a planned or target premium to contribute on a periodic basis (usually monthly) and make the premium payment over an extended period of time. This premium arrangement is “flexible” in that the annuity owner can stop, decrease, or increase the premium payments at will.

REQUIRED PREMIUMS VS OPTIONAL PREMIUMS Most annuities have a minimum annuity premium to purchase a single-premium annuity, and a minimum amount that each additional premium must meet for a flexible-premium annuity. These lower premium limits are set to achieve economy of scale and provide the consumer with a viable product. In addition, in a flexible-premium annuity the annuity owner must continue annuity premiums until the contract meets a minimum stated value. Otherwise the insurer will close the annuity and return the funds to the owner. Most annuities also have upper limits to annuity contributions. These upper limits are usually more than the average consumer has to invest, so they are rarely a limiting factor. In the case of a qualified annuity, such as an IRA or 401(k), the upper limit is based on tax code, and the annuity company (acting as plan administrator) will have to report all contributions to the IRS. There is a potential tax penalty ff the annuity owner contributes more that the relevant tax code section allows. SURRENDER CHARGES AND PENALTIES

While insurance companies independently determine how surrender charges and penalties are structured (subject to state DOI approval), most utilize a charge that decreases over a specified number of years. The charge is usually a percentage of the

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contract values and is also referred to as a contingent deferred sales charge (in the case of a variable annuity). Most insurers apply a surrender charge when either funds are withdrawn (a partial surrender) or the annuity is surrendered (a full surrender) in the early years of the contract. Although not common, some insurance companies apply the surrender charge to each deposit made into the annuity. This type of surrender charge typically applies to flexible-premium annuities. For example, each deposit is tracked by the company, and if withdrawals are made or the contract is surrendered, the surrender charge is calculated based on the amount of the withdrawal/surrender with respect to the size and date of the deposits. For purposes of calculating the surrender charge, if the annuity owner makes a withdrawal, then the funds are considered to be drawn first from the first premiums contributed. An example of a surrender charge schedule might look like the following:

Contract Year Surrender Charge or Penalty

1 8% 2 7% 3 6% 4 5% 5 4% 6 3% 7 2% 8 1%

Note: These surrender charges do not reflect the 10% penalty imposed by IRS if

withdrawals and surrenders are made prior to age 59 ½. MARKET VALUE ADJUSTED ANNUITIES

Some fixed annuities impose a market value adjustment (MVA) on surrenders and withdrawals prior to the end of the index period. MVAs adjust the amount surrendered or withdrawn to reflect the effect of current economic conditions on the value of the insurance company’s invested assets (generally bonds), supporting the guaranteed crediting rate of fixed indexed annuities. Under some fixed indexed annuities, the MVA adjustment can be positive--in which case the withdrawal or surrender proceeds will be reduced--or negative--in which case these proceeds will be increased to reflect asset gains. In every case, however, an MVA adjustment will not be allowed to reduce product values below the minimum guaranteed values required by state insurance law. This provision maintains the insurance status of the product by limiting the degree of investment risk transferred to the owner by insurance company.

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MVAs on annuities and life insurance policies have been around for over a decade, but MVAs on annuities have become much more popular, particularly since early 1990--when the Fed began decreasing rates at a rapid pace. An MVA can be attached to a deferred annuity that features fixed interest-rate guarantees combined with an interest rate adjustment factor. The MVA may cause the actual crediting rates to increase or decrease in response to market conditions.

HOW THE MVA WORKS The contract owner places money in an account that earns a fixed rate of interest. The insurer holds the contract owner’s money in this account for the length of the designated guarantee period. At the end of the guarantee period, there is usually a “window” when no withdrawal charges or market value adjustment will apply.

At the end of the guarantee period, the insurer declares a new current interest rate, or renewal rate, which may be higher or lower than the previous rate but will not be lower the minimum interest rate guaranteed by the policy (typically 3% or 4%).

HOW THE MVA IS DIFFERENT

If a contract owner wants to surrender the annuity prior to the end of the guarantee period, an adjustment will be made. The actual contract value received has the potential to be positively or negatively affected by current market conditions. Because the issuing insurance company has invested the premium to ensure it can pay the rate guaranteed in their contract, it could lose money if it had to sell those investments at a discount to refund premiums paid plus their earnings. The reverse can also be true.

RISK FACTOR The MVA serves to protect the insurance company against investment losses incurred by early withdrawals. When having a more predictable pattern of withdrawals, MVA annuities offer a greater potential to credit higher interest rates than the traditional fixed annuity does. As with equities, bonds, and variable annuity products, MVA annuities provide opportunities for market gain. But they also offer the security found in traditional fixed deferred annuities, typically with no extra sales or administrative fees. In a declining interest-rate environment, the annuitant has the security of a guaranteed rate common to fixed annuities. In addition, due to the bond-like mechanics of the MVA feature, the market-adjusted value of the product actually increases as interest rates decline. In this environment, the credited rate should be better than new money alternatives, which show a decline after the annuity is issued.

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On the other hand, in an increasing rate environment, the market-adjusted value of the contract may decrease, as with a bond. When this happens, insurers offer different product architecture. One may sell a MVA where, unlike a bond, the annuitant is guaranteed the surrender value will never be less than premium paid accumulated at minimum guaranteed interest, less applicable surrender charges. Other insurers may not offer this feature.

CONTRACT ADMINISTRATION CHARGES AND FEES Most insurers charge an annual contract fee per annuity contract, expressed as a flat dollar amount. Some insurers will only charge one annual contract fee per annuity owner regardless of how many separate annuities the annuity owner has with their company. The annual contract fee is usually a nominal amount ($20 to $45 annually) and rarely exceeds $100 per year. The annual contract fee is disclosed in the contract.

CUSTODIAL FEES

In addition to the annual contract fee, there may be additional fees or charges if the annuity is within a qualified plan and the annuity company is acting in a custodial or plan administrator capacity. These additional fees are charged to offset the additional reporting costs associated with a qualified annuity. The custodial/plan administrator fees are usually $15 to $25 per year and will be disclosed in the policy.

SPREAD /ASSET OR MARGIN FEE Some fixed indexed annuities charge a spread fee, or margin fee, as part of the interest crediting formula. Insurance companies that use the spread, or margin, method calculate the increase in the chosen index for that policy year or term, then subtract a percentage from the change. This spread or margin fee is usually expressed as a percentage and will be disclosed in the contract. For example, if the gain in the chosen index for a policy year was 9% and the insurance company used a spread of 2%, 7% would be credited to the contract for that year (possibly subject to a cap). LOADING AND MANAGEMENT FEES

ADMINISTRATIVE FEES Variable annuities will often charge a separate fee for administration and a separate fee for the annual contract fee. The issuing insurance company usually charges an administrative fee expressed as basis points charged against the annuity value.

CONTRACT FEE Many insurance companies charge a flat dollar amount varying from $20.00 to $40.00 per year.

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SUB-ACCOUNT FEES The charges for the operation and management of the sub-account range from .15% to 1.5% of assets. OTHER FEES

In addition to the fees and charges listed above, there can be additional charges for riders such as a death benefit, guaranteed income benefit, or other living benefit. While these charges don’t fall under the heading of Contract Administration Fee or Charges, they are additional expenses that will be charged, and the consumer needs to understand them. WITHDRAWAL PRIVILEGE OPTIONS

As discussed earlier, in addition to the partial and full surrenders previously discussed, annuitants frequently need to access funds for a variety of reasons. Many annuities allow annuitants to withdraw up to 10% of their account value each year without the surrender charges applying to these withdrawals. Similarly, other contracts allow for withdrawals of the interest in the account, or 10% of the contract value, whichever is greater. Still other contracts allow the 10% withdrawal amounts to accumulate each year to allow for accumulated withdrawals of 20%, 30%, 40%, etc. as time goes by. WITHDRAWAL PRIVILEGE OPTIONS QUALIFIED ANNUITIES

If an annuity is a qualified annuity, the annuity will likely amend the wording of the withdrawal privilege option to allow that the amount which can be withdrawn surrender-penalty-free in any given year is the greater of either the stated percent (usually 10%) or the required minimum distribution for that year. These annuities are often described as “RMD friendly”. ANNUITIZATION

All type of annuities will allow the annuity owner to annuitize the annuity. The process of annuitization for each broad category of annuity is described below. It is possible with any type of annuity to have some guaranteed lifetime income rider, annuitization bonus, or other option or rider that will somehow enhance the annuity amounts calculated. Each of these potential enhancements to the annuity amounts should be separately examined for restrictions and benefits. One thing that all annuity products have in common is that annuitization is effectively a trade of the contract values for the annuity benefits (stream of payments) guaranteed in the annuitization option. Annuitization is an irrevocable decision and once started can not be reversed. Most companies will allow an annuity owner to annuitize all or part of the annuity contract.

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INFLATION DURING ANNUITIZATION

Many annuities offer an inflation adjustment or rider during the annuitization (distribution) period. These inflation benefits vary from product to product and should be evaluated separately. ANNUITIZATION OF A FIXED ANNUITY

With the fixed annuity annuitization involves paying out the contract value over the selected annuitization period or option (see annuitization settlement options below). The contract will stipulate the interest rate and mortality tables to be used in the annuitization calculations. ANNUITIZATION OF A VARIABLE ANNUITY

Annuitization is one of the least utilized and most often misunderstood options of a variable annuity contract. The contract owner may elect to allocate all or part of the value of the contract to either the fixed account and/or the separate account. Allocations to the fixed account will provide annuity payments on a fixed basis; amounts allocated to the separate account will provide annuity payments on a variable basis reflecting the investment performance of the underlying subaccount.

FIXED ACCOUNT The contract owner may transfer all or part of the value of the contract to the fixed account, sometimes called the guaranteed account, and elect to annuitize these funds. In essence, for a fixed dollar amount the contract owner purchases a monthly income that will be paid until the contract owner’s death. For example, a 68-year old male could receive a monthly income that would be payable to himself as long as he is alive, or to his beneficiary should he die within the first ten years. This option is known as Life Annuity with Payments for a Guaranteed Period; in this case, the guaranteed period is ten years. Contracts include a payout table stating the minimum payout guaranteed by the insurance company based on age and gender (depending upon state law). When the contract is annuitized, the payout will be based on either the guaranteed amount stated in the table or the current values used at that time, whichever is higher. In this example, according to the payout table, for every $1,000 that is annuitized under the Life Annuity with Payments Guaranteed for 10 Years Option, the monthly payout would be $5.68. This is the amount that was guaranteed at the time the contract was issued. The current payout rate the company is using is $7.93. All payout rates are expressed as dollars per period (monthly, quarterly, semi-annually, annually), per $1,000 dollars.

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If this individual elected to annuitize $30,000, his monthly payout would be $237.90 per month. This payout amount is guaranteed as long as he is alive. Should death occur in the first ten years, his beneficiary would receive the difference between ten years of monthly income and the amount he actually received. SEPARATE ACCOUNT

The contract owner may transfer all or part of the contract value to one or more of the sub-accounts that are available in the separate account. He or she may elect to annuitize those funds. For example, if there were 12 sub-accounts available in the separate account, the contract owner could transfer $25,000 to the Growth & Income sub-account and $30,000 into the international sub-account and annuitize each account. The difference between annuitizing funds in the fixed account and the separate account is that funds in the fixed account produce a guaranteed income that will not change from period to period. Funds that are annuitized in the separate account produce an income that will change from period to period based on the performance of the sub-account in which funds are placed. ANNUITIZATION SETTLEMENT OPTIONS

Settlement options are the methods by which an insurance company pays annuity proceeds to the annuitant, contract owner, or beneficiary(ies). Annuities offer a variety of options to provide annuitants with long-term income payments. Regardless of the type of settlement option, the annuitant may choose to receive payments, monthly, quarterly, semi-annually, or annually. In addition to the settlement options listed below, many annuities offer guaranteed income streams without the need for annuitization.

PERIOD CERTAIN ONLY Period certain means that income payments will be made over a specified number of years chosen by the annuitant. Payments will continue for the duration of the period certain and at the end of that term, will cease. If the annuitant dies before the end of the stated number of years, the beneficiary(ies) continue to receive payments for the remainder of the period certain. Most annuity contracts only allow annuitization over a limited choices of certain periods (3 yrs, 5yrs, 10 yrs etc), however; some annuity contracts allow the annuity owner to specify a dollar amount of the periodic annuity payment and then “back in” to the length of the period certain.

LIFE ONLY

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The life only option provides for payments that continue throughout the life of the annuitant. The annuitant cannot outlive income. Upon the annuitant’s death, however, payments cease, regardless of the length of time payment have been made.

LIFE AND PERIOD CERTAIN

Life and period certain means payments will continue for the rest of the annuitant’s life but for no less than the stated number of years—even if the annuitant dies. If the annuitant dies before the end of the period certain, the beneficiary(ies) continue to receive the payments for the remainder of the period certain.

LIFE ONLY WITH GUARANTEED MINIMUM OPTION The annuitant receives payments that continue for life. If the annuitant dies before the initial investment in the annuity has been repaid, the balance of the initial investment will be paid in like installments to the beneficiary(ies).

JOINT AND SURVIVOR

When a joint and survivor annuity contract is issued on a couple (usually and husband and wife), or if the beneficiary opts for a joint and survivor payout, the contract provides a payout for as long as either of the two annuitants/beneficiaries is alive. The amount of each payment is usually less than if it were based on a single individual. They may choose to have payments either remain the same or decrease after the death of the first annuitant. For example, after the first annuitant/beneficiary dies, the other may choose to have payments reduce to two-thirds of the amount paid while both annuitants were alive. This is called a joint and two-thirds annuity.

DEATH BENEFITS

Most annuities have a death benefit that will be paid to the annuity beneficiary if the annuitant dies before annuitization begins. Once annuitization has begun, the annuitization option will determine what amounts (if any) flow to the beneficiary when the annuitant dies. If the annuitant dies while a surrender charge still applies to the annuity, the amount and timing of the death benefit may be impacted by the surrender charge and/or waivers related to the surrender charge.

TRADITIONAL FIXED-ANNUITY DEATH BENEFIT With a traditional fixed-annuity, the death benefit (prior to annuitization) usually pays the beneficiary an amount equal to total contributions to the annuity, less any withdrawals or loans made during the annuitant’s lifetime and plus the guaranteed interest or actual interest credited.

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FIXED INDEXED ANNUITY DEATH BENEFIT

Since the Fixed Indexed Annuity credits interest based on a formula applied to an external financial index and does so at the end of the index period (usually annually), it is likely that, if the annuitant dies prior to annuitization, it will be during an index period. Since a new index period begins the same day an old index period ends, the probability of the annuitant dying during an index term is addressed in each fixed indexed annuity. While each fixed indexed annuity can vary in the wording of the death benefit, they generally follow the formula below. If the annuitant dies during an index period, and there have been no partial withdrawals, the designated beneficiaries usually receive the greater of:

• The total of premiums paid premium. • The surrender value on the date of death. • The indexed value on the most recent anniversary.

If the annuitant were to happen to die on the day the index period ends, the designated beneficiaries receive the surrender value. Upon death, the proceeds may be distributed in a lump sum or in level amounts; these payments may be made over a certain period of time or during the lifetime of each beneficiary.

VARIABLE ANNUITY DEATH BENEFIT In event of the annuitant’s death during the accumulation period of a variable annuity, most insurance companies include some form of Guaranteed Minimum Death Benefit (GMDB). In a simplified version of the GMDB, the death benefit paid to the beneficiaries is the greater of:

• The contract value at the time of death. • The total premiums paid into the contract. • The contract value on the prior (i.e., 5th, 6th, 7th) Anniversary Date of the

contract. The particular wording of each GMDB can vary among variable annuities and often include a ratchet, anniversary, or high water mark in the computation of the GMDB. The GMDB is a feature that is offered on variable annuities, and a fee is paid by the annuity owner to cover the mortality risks associated with this protection. Like most variable annuity fees, it is expressed as basis points applied to the contract value. DEATH BENEFIT SETTLEMENT OPTIONS

Regardless of the type of annuity, once the amount of the death benefit has been determined, the beneficiary usually has several settlement options available.

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LUMP SUM VS. EXTENDED PAYOUT If the beneficiary is a spouse of the annuitant they often have the option to “assume” the annuity and continue as if they had always been the annuitant. There are potential tax advantages to the assumption of the annuity, and these will be discussed in our Annuity Taxation Chapter. The beneficiary usually has the choice of taking the death benefit in a lump sum or receiving the death benefit amount under one of the annuity settlement options discussed above under Annuity Settlement Options.

DEATH BENEFIT SETTLEMENT OF A QUALIFIED ANNUITY If the annuity death benefit is coming from a qualified annuity, there are several tax considerations that can affect the settlement option chosen, and these will be discussed in detail in our Annuity Taxation Chapter. PRINCIPLE GUARANTEE

SAFETY

A fixed annuity is a safe investment. An authorized insurance company is required to meet its contractual obligations to its policyholders. Its reserves must, at all times, be equal to the actuarially-computed net withdrawal value of it annuity policies issued in a particular risk pool. Additionally, in regulating reserves state law also requires certain levels of capital and surplus to further increase policyholder protection. “Legal reserve” refers to the strict financial requirements that must be met by an insurance company to protect the money paid in premiums by policyholders. These reserves must be equal to the withdrawal value (principal plus interest less any early withdrawal fees) of every annuity policy. A fixed annuity guarantees the safety of invested principal and a minimum rate of return. As long as funds are not withdrawn when subject to a surrender charge, the annuity owner is guaranteed to receive all of their principal and a minimum interest rate. A variable annuity does not guarantee safety of principal unless the annuity owner purchases a Guaranteed Minimum Accumulation Benefit or a Guaranteed Minimum Account Balance, (GMAB…often called a “walk away” benefit), both of which are considered living benefits. In order to take advantage of the GMAB, the annuity owner must satisfy a minimum holding period (usually 3 years or longer) and pay an additional fee for the guarantees offered by the GMAB. Since the underlying subaccounts in a variable annuity can include equity investments, the annuity owner bears the risk to principal unless they transfer this risk through the purchase of a GMAB.

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LOAN PROVISIONS

Most non-qualified annuities do not offer a loan provision. When a loan provision is offered in a non-qualified annuity, there will be interest charged on the loan and a required repayment schedule. Annuities are considered long-term accumulation vehicles and should not be relied upon for short-term cash needs. Many qualified annuities (particularly those used to fund 403(b) and 457 plans) offer a loan provision. There are strict IRS guidelines on the amount that can be borrowed, how it must be tracked, and when it must be repaid (see qualified annuity taxation in our Annuity Taxation Chapter). ADDITIONAL CONTRACT PROVISIONS FIXED INDEXED ANNUITIES

FIXED INDEXED ANNUITIES

Fixed indexed annuities were established in the mid-1990s by insurance companies to compete with popular indexed mutual funds. An indexed annuity earns interest that is linked to a stock or other, such as Standard & Poor's 500 Composite Stock Price Index (the S & P 500). There are a number of different indexes used in indexed annuities, and often the annuity owner can allocate funds within the annuity among several different indexes concurrently. The amount of interest credited to a fixed indexed annuity is determined by a formula applied to one or more external indexes. This formulaic approach to calculating interest is usually called the indexing method, and there are several indexing methods that are used. Most of the indexing methods have “moving parts,” which are values within the indexing calculation that can be adjusted periodically by the insurer. These “moving parts” within the formula are usually guaranteed by the insurer to stay within a certain range (minimum and maximums) for the lifetime of the annuity. These “moving parts” can only be adjusted by the insurer on a forward-looking basis. For example: one of the “moving parts” is often a cap rate (defined later). If a particular fixed indexed annuity has an indexing period of one year, the company must set the cap rate (if any) at the beginning of the indexing year and cannot change that particular moving part until the end of the current indexing year. Another way to put it is that the insurer cannot change a “moving part” on a retrospective basis. The fixed indexed annuity, in its simplest form, is an annuity product that:

1. Provides some of the potential long-term growth of the chosen index. This means that the interest rate credited by the insurance company at the end of each index period (usually policy year) is based on the performance of the chosen index as measured by the indexing formula. The method by which the interest rate is calculated is referred to as the indexing method and may be subject to several moving parts, such as a participation rate, cap rate, floor rate, or administrative/asset fee (defined below).

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2. Is a financial product that provides the downside guarantees of an annuity. This means that once the contract owner makes a premium payment, he or she will never have less value in the account than the sum of premium payments made. Once interest has been credited to the fixed indexed annuity, the value of the annuity will never decrease unless a withdrawal is made and/or a surrender charge applies--even if the chosen index decreases.

INDEXED ANNUITIES VS. TRADITIONAL FIXED ANNUITIES

An equity-indexed annuity differs from other fixed annuities in the way it credits interest to an annuity's value. Most fixed annuities credit interest calculated at a rate stated in the contract. The rate that is credited is determined by the insurance company. Fixed indexed annuities credit interest using a formula based on changes in the index to which the annuity is linked. The formula decides how any additional interest is calculated and credited. How much additional interest a contract owner earns, and when it is credited, depends on the features of the particular annuity. Many equity-indexed annuities promise to pay a minimum interest rate. The rate that is credited to the annuity value is agreed to be no less than this minimum guaranteed rate--even if the index-linked interest rate is lower. The value of an indexed annuity will not drop below a guaranteed minimum amount. For example, many fixed indexed annuity contracts guarantee the minimum value will never be less than 90 percent (100 percent in some contracts) of the premium paid, plus at least 3% in annual interest (less any partial withdrawals). The insurance company will adjust the value of the annuity at the end of each term to reflect any index increases. TERMINOLOGY

PARTICIPATION RATE

PARTICIPATION RATE The participation rate is usually a “moving part”. The participation rate determines how much of the increase in the index will be used to calculate index-linked interest credited to the contract for that year. For example, if the calculated change in the index is 9% and the participation rate is 70%, the index-linked interest rate for the annuity will be 6.3% (9% x 70% = 6.3%). An insurance company may set a different participation rate for newly-issued annuities as often as each day. Therefore, the initial participation rate in the annuity will depend on when it is issued by the insurance company, However, once the participation rate is set by the insurer it cannot be changed for the duration of the indexing period (usually one policy year).

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When that period is over, the company sets a new participation rate for the next period. Some annuities guarantee that the participation rate will never be set lower than a specified minimum or higher than a specified maximum. The participation rate may vary greatly between one annuity to another and may fluctuate over time within a particular annuity. It is important for a contract owner to know how the annuity's participation rate works with the chosen indexing method. A high participation rate may be offset by other features, such as averaging or a point-to-point indexing method. On the other hand, an insurance company may offset a lower participation rate by also offering a feature such as an annual reset indexing method. CAP RATE

CAP RATE OR CAP ON INTEREST EARNED The Cap Rate is usually a “moving part”. Some annuities put an upper limit, or cap, on the index-linked interest rate. This limit is the maximum rate of interest the annuity will earn, regardless of the performance of the index. In the previous example, if the contract has a 6% cap rate, 6%, and not 6.3%, would be the amount of interest credited to the annuity. Not all annuities have a cap rate. While a cap limits the amount of interest earned each year, annuities with this feature may have other product features as well, such as annual interest crediting or the contract owner’s ability to take partial withdrawals. Annuities that have a cap may also have a higher participation rate. The Cap Rate is usually a “moving part” and is guaranteed to never drop below 0%. There is usually no maximum cap rate guarantee. FLOOR RATE

The Floor Rate is usually a “moving part”. Since many fixed indexed annuities guarantee a minimum interest rate regardless of the performance of the index the Floor Rate will only be found in annuities that do not guaranteed a minimum interest rate. The floor rate will state that the annuity will be credited with a minimum rate of return regardless of index performance. When a floor rate is present it is usually guaranteed to never fall below zero. SPREAD/ MARGIN/ASSET FEE

The Spread/Margin/Asset fee is usually a “moving part”. Instead of a Cap Rate and/or Participation Rate, some insurers use a fee (called a spread/margin or asset fee) whereby they calculate the movement in the chosen index for that policy year or term, then subtract a percentage from the change. For example, if the gain in the chosen index for a policy year was 8% and the insurance company used a spread of 2%, 6% would be credited to the contract for that year.

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When a company chooses to use this approach, the maximum fee that can be charged is guaranteed for the life of the contract. RATCHET OR ANNUAL RESET

Many people mistaken assume that a Ratchet or annual reset is an indexing method, and that is not true. The ratchet, or annual reset, locks in the gain for the just-completed interest-crediting term. It does so by using the ending index value from the just-completed indexing term as the beginning value of the index for the ensuing indexing period. Once the interest is credited to the contract, it becomes part of the value of the annuity contract even if the index drops in future years. The index calculation for each policy year stands alone. Once an annuity contract has been credited with its gain for a particular year, the gain can never be taken away. If the index should experience a drop in value, the fixed indexed annuity is protected. COMMON INDEXING STRATEGIES

INDEXING METHOD One of the most confusing aspects of indexed annuities is the method the company uses to calculate the interest credited to the contract. The indexing method is the approach used to measure the amount of change, if any, in the index. Some of the most common indexing methods are explained more fully below. All indexing methods essentially measure the change in the chosen index over some period of time. The time periods used are either the policy year, from the day the policy is issued, or a specific term, a period of one or more years.

SPECIFIC TERM The following example best explains how “specific term indexing” works. Assume the chosen index is the S & P 500 and the specific indexing term for the annuity is 5 years. The S & P 500 index had not reached 500 on the day Bob’s contract was issued. Over the 5 year term of his contract, the highest point the S & P 500 reached was 700. The gain of 200 points represents a 40% increase; therefore, the value of Bob’s contract would be increased by 40%. An annuity contract with an initial premium of $100,000 would be credited with $40,000 of interest five years later—at the end of the specific term.

POLICY YEAR An example for illustrating the policy year calculation feature follows. Assume the chosen index is the S & P 500 and the indexing term for the annuity is “policy year”. The S & P 500 was at 500 on the day Steve’s contract was issued. During the policy year of his contract, the highest point the S & P 500 reached was 550. The gain of 50 points

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represents a 10% increase, subject to any applicable caps; therefore, the value of Steve’s contract would be increased by 10%. An annuity contract with an initial premium of $100,000 would be credited with $10,000 of interest at the end of the policy year. Both the specific term and policy year method examples above used the High Water Mark Indexing Method (described below) in determining how much interest to credit to the annuity for the index period just ended.

INDEXING METHODS CALCULATE PERCENTAGE CHANGE The change in the chosen index from the beginning of the term to the end of the term is expressed as a percentage. The term could be one policy year, five policy years, seven policy years, etc. In years where the chosen index is negative, the percentage credited to the contract is zero (0). In this case, there would be no change in the policy value. Now let’s take a look at the most common indexing methods. Remember that all of these indexing methods potentially involve a participation rate, cap rate, floor rate, and annual reset.

FIXED INTEREST Most Fixed Indexed Annuities allow the annuity owner to allocate part or all of their annuity values to a fixed interest bucket where the fixed rate is announced in advance and guaranteed for the year. This is very similar to a traditional fixed annuity.

MONTHLY AVERAGING The averaging method of indexing calculates the change in the indexing by averaging the closing index values for the same day each month during the index term. If the index term is one year, the insurer would add the closing index values for each of the twelve months during the index term and divide by twelve. The result of this calculation would be used as the ending value of the index and then compared to the index value at the beginning of the index term to determine percent change in the index.

DAILY AVERAGING

In addition to monthly averaging, some annuities offer daily averaging, which works the same as monthly averaging except that the closing value of the index for every day of underlying index is averaged together instead of just twelve month-end values. On the following page is an example of monthly averaging.

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Below is an example of the Monthly Averaging Indexing Method

• The first of each month is the measurement day.

• For illustration, all index values are only expressed in whole numbers and percents are only carried out two decimal positions.

• Indexing term is one year.

Date Month Index Value Jan 1, 2010 Begin 1,000 Feb 1, 2010 1 1,014 Mar 1, 2010 2 1,020 April 1, 2010 3 1,033 May 1, 2010 4 1,066 June 1, 2010 5 1,019 July 1, 2010 6 1,024 Aug 1, 2010 7 1,033 Sept 1, 2010 8 1,056 Oct 1, 2010 9 1,064 Nov 1, 2010 10 1,038 Dec 1, 2010 11 1,044 Jan 1, 2100 12 1,061 Total of 12 Monthly Index Values

12, 472

Average of 12 Monthly Index Values

1,039

This example is for agent use only and is not to be used with consumers. This is only an illustration for understanding how Monthly Averaging Indexing works and is not a representation of past history or a prediction of the future movement of any index. In the above example, the average of the 12 monthly index values is 1,039, and this number would be used as the ending index value in the calculation. The interest credited would be as follows: Ending index value divided by beginning index value, minus 1:

Step 1: 1,039 ÷ 1, 000 = 1.039 Step 2: 1.039 – 1 = .039 or 3.9%

Unless there is a cap, participation rate, or spread/ margin/asset fee that limits the calculation, the annuity would be credited with 3.9% interest for the year illustrated.

POINT-TO-POINT INDEXING Point-to-point is one of the methods commonly used to measure the change in a chosen index. The index-linked interest, if any, for point-to-point indexing is based on the difference between the index value at the end of the term and the index value at the start

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of the term. Interest is credited to the annuity at the end of the term. The term period is most commonly policy year (one year), but may be up to five policy years.

ANNUAL POINT-TO-POINT INDEXING Annual Point-to-Point is the easiest indexing method for most people to understand. Point-to-point indexing can be used as monthly point-to-point, annual point-to-point, or long term point-to-point.

EXAMPLE Below is an example of the Annual Point-to Point-Indexing Method using the following assumptions:

• Policy year runs from January1, 2010 to January 1, 2011.

• For illustration, all index values are only expressed in whole numbers and calculation are not carried beyond three decimal positions.

• Indexing term is one year.

Date Month Index Value Jan 1, 2010 Begin 1,000 Feb 1, 2010 1 1,014 Mar 1, 2010 2 1,020 April 1, 2010 3 1,033 May 1, 2010 4 1,066 June 1, 2010 5 1,019 July 1, 2010 6 1,024 Aug 1, 2010 7 1,033 Sept 1, 2010 8 1,056 Oct 1, 2010 9 1,064 Nov 1, 2010 10 1,038 Dec 1, 2010 11 1,044 Jan 1, 2100 12 1,061 This example is for agent use only and is not to be used with consumers. This is only an illustration for understanding how Annual Point to Point Indexing works and is not a representation of past history or a prediction of the future movement of any index. In the example above Annual Point-to-Point Indexing would divide the ending index value by the beginning index value and then subtract 1 as follows:

Step 1: 1,061 ÷ 1,000 = 1.061 Step 2: 1.061 – 1 =.061 or 6.1%.

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In the example above the interest credited to the annuity for the index term just ended would be 6.1% unless lowered by a participation rate, cap rate, or spread/margin/asset fee.

MONTHLY POINT-TO-POINT INDEXING Monthly point-to-point works differently. In monthly point-to-point the indexing term is usually policy year, so that is how we will explain it, but it is available over a two or three year period. Monthly point-to-point indexing measures the movement in the index value from the same day each month to the same day in the next month to determine the monthly movement in the index. If the monthly movement in the index is positive, it is used in the calculation, though there is usually a cap on how much monthly upward movement can be used in the calculation (usually 2.5% to 3% per month maximum). If the monthly movement in the index is negative, it is used in the calculation and there is usually no limit on the amount of monthly downward movement in the index that can be used in the calculation. At the end of the policy year the insurer will add up the twelve monthly movements in the index value to determine the change in the index to be credited to the annuity. Since the monthly-point-to-point indexing formula is already subject to a monthly cap on the upward movement, there is usually not a cap rate applied to the overall end result of the twelve months. However, a Participation Rate or Spread/Margin/Asset fee may apply. On the following page is an example of monthly point-to-point indexing using the following assumptions:

• A monthly cap of 2.5% per month on the amount of upward index movement used in the calculation.

• No monthly cap on the amount of downward movement of the index used in the calculation.

• The first of each month is the measurement day.

• For illustration, all index values are only expressed in whole numbers and calculation are not carried beyond three decimal positions.

• Indexing term is one year.

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EXAMPLE

Date Month Index Value % Change Used in Calc Cumulative Jan 1, 2010 Begin 1,000 Begin Feb 1, 2010 1 1,014 1.40% 1.40% 1.40% Mar 1, 2010 2 1,020 0.59% 0.59% 1.99% April 1, 2010 3 1,033 1.27% 1.27% 3.26% May 1, 2010 4 1,066 3.19% 2.50% 5.76% June 1, 2010 5 1,019 (4.41%) (4.41%) 1.35% July 1, 2010 6 1,024 0.49% 0.49% 1.84% Aug 1, 2010 7 1,033 0.88% 0.88% 2.72% Sept 1, 2010 8 1,056 2.23% 2.23% 4.95% Oct 1, 2010 9 1,064 0.78% 0.78% 5.73% Nov 1, 2010 10 1,038 (2.44%) (2.44%) 3.29% Dec 1, 2010 11 1,044 0.59% 0.59% 3.88% Jan1, 2011 12 1,061 1.63% 1.63% 5.51% This example is for agent use only and is not to be used with consumers. This is only an illustration for understanding how Monthly Point-to-Point Indexing works and is not a representation of past history or a prediction of the future movement of any index. In the above example, the monthly point-to-point indexing calculation would result in interest crediting of 5.51% for the indexing year. The 5.51% represents the total of the monthly up or down movements in the index value as measured by the calculation. If a participation rate or Spread/Margin/Asset fee was present in the calculation, this would reduce the amount credited to the annuity. Note: In month 4 the index rose 3.19%, but only 2.5% was used in the calculation due to the monthly Cap.

LONGTERM POINT-TO-POINT INDEXING Long Term Point-to-Point indexing works like Annual Point-to-Point Indexing, except that the indexing period is longer than one policy year. Usually it is a two or three year indexing term.

HIGH WATER MARK INDEXING With High Water Mark Indexing the highest index value (high water mark) during the indexing period is used as the ending index value, and the beginning index value at the beginning of the indexing period is used as the beginning value. Interest is based on the difference between the highest index value (high water mark) and the index value at the start of the term. The indexing term for most high water mark indexing is from 1 to 3 years.

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Below is an example of the High Water Mark Indexing Method using the following assumptions:

• For illustration, all index values are only expressed in whole numbers and calculation are not carried beyond three decimal positions.

• Indexing term is one year.

Date Month Index Value High Water

Mark Jan 1, 2010 Begin 1,000 Feb 1, 2010 1 1,014 Mar 1, 2010 2 1,020 April 1, 2010 3 1,033 May 1, 2010 4 1,066 June 1, 2010 5 1,019 July 1, 2010 6 1,024 Aug 1, 2010 7 1,033 Sept 1, 2010 8 1,056 Oct 1, 2010 9 1,064 1,064 Nov 1, 2010 10 1,038 Dec 1, 2010 11 1,044 Jan 1, 2100 12 1,061 This example is for agent use only and is not to be used with consumers. This is only an illustration for understanding how High Water Mark Indexing works and is not a representation of past history or a prediction of the future movement of any index. In the example above High Water mark Indexing would divide the ending index value (which is the high water mark occurring in month 9) by the beginning index value and then subtract 1 as follows:

Step 1: 1,064 ÷ 1,000 = 1.064 Step 2: 1.064 – 1 =.064 or 6.4%

In the example above the interest credited to the annuity for the just-ended index term would be 6.4% unless lowered by a participation rate, cap rate, or spread/margin/asset fee. COMBINATION OF INDEXING METHODS

Many fixed indexed annuities allow the annuity owner to allocate funds among several different indexes and indexing methods within the same policy year. In this case the annuity owner could have three or more “buckets” of money using different indexes and different indexing methods.

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CONSUMER CHOICE TO ALLOCATE/REALLOCATE AMONGST STRATEGIES

When the annuity owner has the ability to choose among several indexes and indexing methods, they usually have the ability to reallocate the funds to other indexes and/or indexing methods on an annual basis. An exception to the annual reallocation occurs when some or all of the funds are currently in an indexing strategy that has an indexing period of longer that one year. INDEX STRATEGY PERFORMANCE

FLUCTUATION OF CAP AND PARTICIPATION RATES

As was discussed earlier in this text, Participation and Cap Rates are usually “moving parts” in the interest crediting formulas used in fixed indexed annuities. Participation and Cap Rates can be adjusted by the insurer (usually subject to minimums guaranteed for the life of the contract). The reason these rates are “moving parts” and will fluctuate has to do with how the insurer invests the annuity premiums allocated to the indexing strategies. The majority of annuity premium received is used to support the product’s minimum guarantees. As with any fixed annuity, the funds used to back these guarantees are invested in bonds and other long-term instruments. INSURER INVESTING TO HEDGE INDEXING STRATEGIES

Once the minimum guarantees have been actuarially reserved, the remaining portion of the premium can be used to cover expenses and purchase index options. These index options provide the ability for the insurer to credit gains in the index to annuity contracts. Different companies use different strategies to perform their index hedging, but they all utilize index options in one way or another to provide index-linked interest to their annuity owners. The cost of these index options will vary during different economic environments, and most companies do not spend their entire options budget up front due to the fluctuation in the costs of index options. If the cost of index options increases significantly, the insurer can adjust the Cap Rate or Participation Rate on a prospective basis to sufficiently lower the future liability to the annuity owners to bring the option’s cost within budget. Most insurers purchase index options with a “strike date” (option life) one year or less in the future. This helps to understand why the Cap Rate and Participation Rates are usually guaranteed for a year at a time. Each year the insurer has to purchase index options to cover any index gains that may be credited during the ensuing year. If the cost of index options were to decrease, the insurer could afford to increase the Participation and Cap Rates for the upcoming year.

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Option costs fluctuate year to year based on market conditions, so if the price of options is higher in a given renewal year than what was assumed at the time the policy was issued, fewer options can be purchased. The end result in this scenario is that renewal caps on the policy will have to be lowered (fewer options purchased translates in to a lower cap). Conversely, lower option costs result in higher renewal caps. FACTORS AFFECTING INDEX OPTIONS PRICES

There are two main factors that drive the costs of index options: market volatility and guaranteed rates of return. MARKET VOLATILITY

The performance of the equity markets do fluctuate and the greater the “swing” in performance and the shorter the time frame, the more volatile the equity markets are. Market volatility affects the likelihood that an option will pay off and is used to predict the standard deviation expected for the coming year in a specific stock index. This has a big impact on the pricing of index options.

Depending on the indexing method used within a particular annuity, a different type of index option will be purchased. The price of an index option purchased to hedge against a Monthly Point-to-Point indexing method will react differently to increased market volatility than an index option purchased to hedge an Annual Point-to-Point indexing method.

RISK FREE RATE OF RETURN

The most commonly used benchmark for Risk-Free Rate of return is the rate of return on U.S. Government-issued Treasuries. An increase in the Risk-Free Rate of Return usually causes the price of options to increase, and a decrease in the Risk Free Rate of Return will usually cause a decrease in the price of options. MID - TERM WITHDRAWALS

With most fixed indexed annuities, if a withdrawal is made during the index term, no index credits are granted on funds withdrawn. Because the amount of interest to be credited is calculated based upon the index movement during the index term (which has not yet occurred), the insurer doesn’t know what amount of interest to credit to a withdrawal or surrender during the index term. If an insurer took the approach of determining the interest that would be credited if the calculation were performed on the withdrawal date (in effect shortening the index term), it might place them at risk of an annuity owner trying to time the withdrawal at a point when the interest would be the greatest. The longer the index term, the greater the likelihood that any unplanned withdrawal made by the annuity owner will be mid-term. Liquidity is always a suitability issue when

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selling an annuity, and this is another good example indicating that the annuity owner needs to have other funds within their financial household that can serve as an emergency fund. Lack of interest being credited to a midterm withdrawal is a separate issue from the surrender charge. MINIMUM NONFORFEITURE RATE VS. MINIMUM ANNUAL CREDITED RATE

THE MINIMUM NONFORFEITURE RATE

Annuity issuers are required to comply with the minimum nonforfeiture interest rate requirements in the state of issue. Most states require between 1% and 3% minimum nonforfeiture rates for the life of the annuity, with the amount to be guaranteed potentially fluctuating with the 5 year Constant Maturity Treasury Rate less 125 basis points. If dealing with an indexed annuity that allows “substantive” participation in the performance of an index, up to 225 basis points can be deducted from the 5 year Constant Maturity Treasury Rate. In addition, an insurer can re-determine the nonforfeiture amount as economic conditions change. This re-determination is not used often due to the administration and tracking required. The method for calculating the minimum nonforfeiture rate and amount does not have to be disclosed in the annuity contract in most states. THE MINIMUM ANNUAL CREDITED RATE

The contractual guaranteed interest rate to the consumer must meet or exceed the statutorily required minimum non-forfeiture value. Unlike the minimum nonforfeiture rate and amount, the minimum guaranteed value must be clearly defined in the contract. In some annuities these rates and amounts are the same because the guaranteed value is going to equal the non-forfeiture value, but they can be different.

The annuity contract must define clearly what the guaranteed minimums are, and the company needs to demonstrate separately to the commissioner that the contractual guarantees listed in the contract meet or exceed the required minimum non-forfeiture value. A typical minimum credited annual rate for a fixed indexed annuity is 90 percent of principal growing at 3 percent. An interesting note is that the most states’ minimum nonforfeiture regulations require a separate bucket if a fixed indexed annuity has a fixed account in it. In this situation, there is a non-forfeiture rate associated with the fixed account or the fixed option, and this rate would be the 5 year Constant Maturity Treasury Rate minus 125 basis points. There can also be a separate rate for the indexed money, which would be the five-year Constant Maturity Treasury Rate minus 225 basis points.

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HISTORICAL PERSPECTIVES

HYPOTHETICAL MODELS

Hypothetical illustrations are susceptible to manipulation in various ways. The most common way a hypothetical illustration can be manipulated is by “cherry picking” the period of time to illustrate. In theory a hypothetical return is an illustration of a “what- if” scenario that is “back tested” with some period of actual results. The hypothetical illustration usually compares two or more investment vehicles over the same time period to show that one is superior to the other. When hypothetical illustrations are used in marketing literature, rest assured that the marketing department will never pick an unfavorable period of time to illustrate. Rather, they will pick the period that tells a happy story. ACTUAL RETURNS

A truer test of the anticipated future performance of a financial vehicle is the actual past performance of that same vehicle with all of the associated fees and expenses shown as well as illustrations of the “walk away” value the product owner was able to take with them, net of all transaction fees. RENEWAL RATES

It is often asked why the caps on newly-issued policies are often different than renewal caps on older policies. This difference is primarily driven by the bonds that were purchased to back the policies. If, for example, interest rates have risen since a policy was issued, newly-issued policies will be supported by bonds that offer a higher yield. With higher yields, less money is needed to support the minimum guarantees and more money can be allocated to the purchase of index options. With more options, of course, higher caps can be offered on new policies than the renewals. The reverse would be true in a falling interest rate environment; new policies would have less money allocated for option purchases, which would result in lower caps as compared to caps offered on renewals.

Option prices fluctuate year to year based on current market conditions, so if the price of options is higher in a given renewal year than what was assumed or budgeted at the time the policy was issued, fewer options can be purchased. The end result is that renewal caps on the policy will have to be lowered (fewer options purchased translates in to a lower cap). Conversely, lower option prices result in higher renewal caps. COMMON INDEXES USED IN FIXED INDEXED ANNUITIES

The two most commonly used indexes in fixed indexed annuities are the S & P 500 and the Dow Jones.

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STANDARD & POOR’S 500

This is an index which was devised a number of years ago by the Standard & Poor's Company. Today the S & P 500 Index is widely regarded as the benchmark index by which U.S. stock market performance is measured. The S & P 500 includes a representative sample of common stocks traded on the New York Stock Exchange, American Stock Exchange, and NASDAQ National Marketing System. It is one of the U.S. Commerce Department’s leading indicators. In addition, it represents over 70% of the total domestic U.S. equity market capitalization. The S&P 500 Index originated in 1923 when Standard & Poor's introduced a series of indexes that included 233 companies and covered 26 industries. The Index, as it is now known, was introduced in 1957. Today, the S & P 500 encompasses 500 companies representing 90 specific industry groups. The S & P 500 does not contain stocks of the 500 largest companies as many think. Although many of the stocks in the Index are among the largest, some relatively small companies are also included. However, these small companies are generally leaders within their industry groups.

VARYING VIEWS Some individuals are skeptical of the use of the S & P 500 index for fixed indexed annuities. The heart of this skepticism lies in the fact that the S & P 500 does not include dividends. Dividends have accounted for a large percentage of total investment return over the past 20 years. Skeptics feel that foregoing dividends while experiencing a cap on market capital gains may be too severe a penalty for some investors to pay for protection against periodic market losses.

COMPARISON TO THE DOW JONES INDUSTRIAL AVERAGE The Dow Jones Industrial Average is the oldest index and, probably, the most well known gauge of stock market performance. The Dow is composed of 30 large capitalization blue-chip stocks and measures the performance of a relatively small sector of the market. The Dow does adjust for dividends. AVAILABLE ANNUITY RIDERS

LIFE INSURANCE RIDERS

Some annuities offer a life insurance rider as an option when purchasing an annuity. Offering a life insurance rider on an annuity will sometimes (but not always) involve medical underwriting similar to when purchasing a life insurance policy. In light of the recent examples of Stranger Originated Annuity Transactions, look for more annuity issuers to require medical underwriting when a life insurance rider is offered on an annuity.

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Unlike most other assets, annuities do not receive a step-up in cost basis at the death of the owner/annuitant; therefore the beneficiary will owe ordinary income tax on all of the earnings in the annuity. If an annuity is being used as a wealth transfer vehicle, the annuity owner may want to consider using life insurance to provide a tax-free death benefit to their annuity beneficiary to help the beneficiary pay taxes on the annuity proceeds. For this reason some annuity companies will offer a death benefit equal to 25% -35% of the annuity value at death. The reasoning used in determining the amount of the life insurance death benefit is that 25% to 35% approximates the potential tax liability if the beneficiary liquidates the annuity in one tax year. LONG-TERM CARE RIDERS

Some annuities offer a long-term care rider. These long-term care riders will occasionally qualify as a “qualified” long-term care rider under the Heath Insurance Portability and Accountability Act, but most often do not. These LTC riders are designed to help pay the costs associated with long-term care services. Some annuities will provide this benefit if the annuitant suffers an illness or injury that requires a home health aide or nursing home care confinement. Some annuities will provide this benefit if the annuitant AND/OR their spouse meets the above benefit trigger. The amount of the benefit will usually be a percent or factor of the annuity values at the time of claim. The duration of the benefit will depend on the spend rate and the amount of the benefit. There are several ways these LTC riders are structured. In all three basic LTC approaches, if the annuity is charged a premium for an LTC rider that provides some of the LTC benefits, the account value of the Annuity also provides part of the benefit. In most annuities with an LTC rider, the annuity account value can be exhausted in the process, leaving the annuity owner without any remaining annuity values. The three basic approaches to LTC riders are discussed below.

ACCOUNT BALANCE FIRST LTC APPROACH One approach to the LTC benefit is to first spend the account balance of the annuity to provide the LTC benefit, and then use the insurance that was purchased to provide a tail balance.

ACCOUNT BALANCE LAST LTC APPROACH Another approach first uses the insurance purchased via the rider premium until it is exhausted, and then begins to exhaust the annuity account value.

COINSURANCE LTC APPROACH Yet another approach employs both the account balance and the LTC insurance purchased with the rider simultaneously. In this case the LTC insurance pays a portion of the benefit and the account balance pays the remaining amount. There are differences in the premiums charged for each of these approaches and in the taxation of premiums and annuity account balances as they are liquidated.

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WAIVER OF SURRENDER CHARGE VS. LTC RIDER While most annuities offer some level of waiver of the surrender charge if the annuitant is confined to a LTC facility (and this is a good thing), the waiver should not be confused with a long-term care rider. The LTC rider can provide a benefit that will pay for a wider array of LTC services than the surrender charge waiver applies to (the waiver of surrender charge usually requires confinement). In addition the waiver is not LTC insurance and does not increase the ability of the annuitant to pay for LTC services beyond what they can withdraw penalty-free form the annuity.

GUARANTEED MINIMUM WITHDRAWAL BENEFIT RIDERS A guaranteed Minimum Withdrawal Benefit Rider is a rider that can be added to an annuity (for a fee), and the rider will guarantee either that a certain minimum withdrawal amount can be taken from the annuity for a specified minimum time period or that a certain minimum percent of the account balance can be withdrawn annually for the life of the annuitant. Unlike annuitization, the annuity owner retains some liquidity in the contract plus the account can still be annuitized in the future if the annuitant chooses to do so.

GUARANTEED MINIMUM WITHDRAWAL BENEFITS IN VARIABLE ANNUITIES Many fixed annuities now offer some form of a Guarantee Minimum Withdrawal Benefit, but the genesis of this benefit is within the variable annuity market. When GMWB benefits were first introduced with variable annuities, they came in two basic versions, both of which were designed to protect the initial investment in the contract by giving back the initial deposit in the event the market value of the annuity dropped below the original investment amount. However, the annuitant did not get back the principal in a single, lump sum payment. Rather, the payout was made in systematic payments over a period of years. Some products offered withdrawals of 7% of the initial balance every year for 14.2 years. Other products offered withdrawals of 5% per year for 20 years. If the annuitant elected one of these options and the investments performed well, they may have found additional money left in the contract at the end of the withdrawal period. Later versions of GMWB benefits began offering withdrawals of 5% guaranteed for the rest of the annuitant’s life. At older ages, because life expectancy gets shorter and shorter, the annuitant is commonly offered higher withdrawal rates.

VARIATIONS

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One attractive feature of GMWB benefit is that it offers the ability for withdrawal amounts to increase if the future market value goes up or the ability for amounts to be left in the annuity at the end of the withdrawal period, all without annuitization. Keep in mind, however, what it would take for that to happen. If an annuitant makes withdrawals of 5% or more from the account, and the annuity itself carries total charges in the neighborhood of 3%, that’s a total of 8% coming out of the account value every year. Each year that the investment portfolio produces a gross return of less than 8%, the account value will decrease and, therefore, gross returns in excess of 8% are necessary to grow the account value and produce future increases in withdrawal amounts (using the expense and withdrawal assumptions above). As such, these guarantees provide great peace-of-mind knowing that, even if the account balance goes to zero, income distributions will continue.

INVESTMENT RESTRICTIONS WITH GMWB Because high volatility in the annuity account value increases the cost of GMWB benefits, GMWB products also commonly include some sort of investment restriction to control account value volatility. Many contracts accomplish this by requiring all funds to be allocated to specified model portfolios. Even then, the more aggressive model portfolios are often not available when wanting to take advantage of the GMWB features. These products also commonly contain incentives for delaying withdrawals. For some products, the annuitants are rewarded for waiting a specified number of years after the annuity is issued. Other products reward annuitants if they reach a certain age before withdrawals begin. Some will include BOTH incentives.

GUARANTEED MINIMUM WITHDRAWAL BENEFIT RIDERS IN FIXED ANNUITIES A number of fixed annuities now offer a GMWB, and they share many of the characteristics with the GMWB offered in a variable annuity. The terminology used in the fixed annuity riders varies somewhat from the variable annuity rider. Most GMWB s offered in a fixed annuity will have a “roll-up period,” which is the period of time after the account is established and before benefit is elected from the GMWB rider. During this “roll-up period” many fixed annuities increase the base on which the GMWB will be calculated by either the actual index interest credit or a specified minimum percentage, whichever is greater. It should be noted the Guaranteed Minimum Withdrawal BASE is only a value that can be accessed via the GMWB rider and does not represent a surrender value or the value to be used for annuitization. One the GMWB rider is elected, the annuitant can withdraw up to a certain percentage (based on how long “the roll-up period” was and the annuitant’s age and/or their spouse’s age in the case of a joint withdrawal). As long as withdrawals do not exceed the maximum amount allowed in the GMWB rider, most of the fixed annuities with the

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GMWB rider will provide this benefit for life (or joint life as the case may be). This sounds a lot like annuitizing without actually annuitizing, except that there are some taxation differences. Since you are taking withdrawals and not annuitizing, the gain in the annuity is recognized under the “interest-first method,” which is different from gain recognition during annuitization. See the chapter on Annuity Taxation for a discussion on this issue. Once the GMWB benefit has been elected and withdrawals have begun, the annuity owner still has some liquidity in the contract and can vary the amount they withdraw above or below the calculated withdrawal amount and/or surrender. They can also annuitize the contract. GUARANTEED MINIMUM DEATH BENEFIT RIDER

A guaranteed minimum death benefit rider has always, in effect, been offered in some form or another by fixed annuities because they have always had to comply with nonforfeiture rules. It was the variable annuity which popularized this rider in order to satisfy the prospective variable annuity owner’s fear of dying at a time when their market based annuity value was low. The first major innovation to begin the variable annuity revolution was the Guaranteed Minimum Death Benefit (GMDB). This new feature gave variable annuities the ability to do something no other equity-based investment did – provide upside market potential while protecting from the downside of adverse market performance. To begin to understand the history of the variable annuity revolution, let’s look a little more closely at how these death benefits worked. When guaranteed minimum death benefits first arrived on the scene, they were designed to prevent an investor from losing money in the market. Insurance companies made this assertion by guaranteeing investors that, if they died at a time when the market was down, they would never get back less than the original principal invested. This guarantee gave them a return of their money and protected their beneficiaries against market losses. Although the excitement of this protection gave new life to the sales of variable annuities, innovation pressed on, and soon new improvements began reshaping the landscape of variable annuity death benefits. The first enhancement was the introduction of death benefits that guaranteed to return more than the initial principal. These enhanced death benefits generally came in one of two forms.

GMDB - BASIC FORM In an effort to address the downside risks associated with equities, the insurance companies began to offer a Guaranteed Minimum Death Benefit Rider. It offered downside market protection at death. In its original form, the rider promised that if the annuitant died, the beneficiaries would be guaranteed either the account value at death or

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a return of principal, whichever was greater. This basic GMDB rider appealed to investors and covered markets risks associated with equity investing--but only did so if the client died.

GMDB - ENHANCED Insurance companies began to enhance the basic GMDB by stipulating that, in addition to a guarantee of a return of principal at death (or account value if higher), the company would add a nominal interest rate to the guarantee. The enhanced GMDB offered a guarantee equaling more than the original investment. These enhanced benefits generally came in one of two forms. Principal compounded at a fixed rate The enhanced GMDB guarantees a return of all principal plus interest compounded at a specified annual percentage rate. Often, this enhanced benefit is not effective until at least the third contract anniversary. The contract owner is assured that if death occurs while owning the variable annuity, the beneficiaries will receive the principal invested plus a reasonable rate of return if this amount is greater than the actual annuity value at death. The annual percentage rates offered in this form of enhanced GMDB are usually set slightly above those of most fixed instruments such as CDs and bonds for the purpose of being competitive. It should be noted that a GMDB does not protect the owner from market risks, but rather protects the beneficiaries. Anniversary Ratchet GMDB Sometimes called the high water mark anniversary guarantee, this form of enhanced GMDB takes a snapshot of the annuity value at each anniversary and guarantees the beneficiary the minimum of the amount invested, actual account value at death, or (if greater) the highest value of the annuity on any previous contract anniversary date.

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Chapter 1 - Review Questions (Answers are in the back of the text)

1. A variable annuity fluctuates in value according to the performance of which of the following?

(a) Trust accounts (b) General accounts (c) Separate or sub accounts (d) Bank accounts

2. Which of the following best describes the growth inside an annuity?

(a) Tax-free (b) Tax-deferred (c) Annuities do not experience growth (d) Annuities are not subject to taxation

3. Single Premium annuities can be classified into two types. Which of the following best describes the two types of Single Premium annuities?

(a) Variable and Fixed (b) Immediate and Deferred (c) Guaranteed and non-guaranteed (d) Tax-free and taxable

4. An annuity that makes payments to two individuals for the lifetimes of each person is called which of the following?

(a) Joint, or Joint and Survivor (b) Period Certain (c) Annuities cannot make payments to two people (d) Variable

5. Indexed annuities credit interest using a formula based on which of the following?

(a) An external financial index (b) A fixed rate of interest (c) The stock market (d) Indexed annuities do not credit interest

6. Which of the following terms applies when an insurance company credits interest by subtracting a percentage from the index increase?

(a) Interest rate decrease

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(b) Unfair trade practice (c) Spread margin or asset fee (d) Taxable income

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CChhaapptteerr 22 Annuity Taxation and Primary Uses of Annuities TAXATION OF NON-QUALIFIED ANNUITIES

A non-qualified annuity is an annuity that is not inside of a qualified retirement plan such as an IRA or 401(k). The money deposited into an annuity (contributions) is referred to as a premium, and in a non-qualified the premium becomes the income-tax cost-basis for determining which portion of the annuity is subject to taxation upon withdrawal. Premiums contributed to a non-qualified annuity are made with after-tax money and are not deducted from taxable income. Since income taxes have already been paid on the premiums contributed to a non-qualified annuity, those premium dollars are never again subject to income taxation. The money deposited into an annuity may earn interest, receive dividend income, or earn capital-gain distributions. For the purposes of this discussion on annuity taxation we will collectively refer to these various increases in the value of an annuity as earnings. These earnings--unlike earnings in a savings account, mutual fund, or certificate of deposit--are not taxed in the year in which they are earned. Thus the earnings continue to grow and compound, tax-deferred, until withdrawn.

NOTE: All earnings on all annuities are taxed as ordinary income when withdrawn. Capital-gains tax treatment is NOT available for earnings from ANY annuity.

WHEN AN ANNUITY IS OWNED BY A NON-NATURAL PERSON

A non-natural person could be a corporation, partnership, or trust. In most cases, an annuity owned by a non-natural person is not treated as annuity for federal income tax purposes; therefore, earnings on annuities owned by non-natural persons are taxed in the year received (or credited to the annuity) as ordinary income. EXCEPTIONS

There are several exceptions to an annuity owned by a non-natural person not being taxed as an annuity.

• Immediate annuities are excepted from this rule.

• An annuity contract will be treated as owned by a natural person if the owner is a trust or other entity which holds the annuity as an agent for a natural person.

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NOTE: This exception does not apply in the case of an employer who is the owner of an annuity contract under a nonqualified deferred-compensation arrangement for its employees.

NOTE: If owner of an annuity is a grantor trust, the death of grantor triggers mandatory distribution. This does not apply to annuities issued prior to January 19, 1985.

TAXATION OF WITHDRAWALS FROM NON-QUALIFIED ANNUITIES

TOTAL SURRENDER

When a non-qualified annuity contract is fully surrendered in a single lump sum transaction, the owner must pay income tax on all of the earnings in the contract. Earnings are determined as the excess amount received over the amount of premiums paid, calculated upon surrender.

PARTIAL WITHDRAWAL

Partial withdrawals from a non-qualified annuity that are not payments under an annuity settlement option are taxed on a last-in, first-out (LIFO) basis. This is actually called the earnings-first method of gain recognition. In order words, withdrawals from an annuity are made earnings-first, and the owner is taxed on the payments until all of the earnings have been distributed. This assumes the cost-basis is the last portion of be withdrawn from the annuity. There is an exception to the earnings-first rule for contributions made to annuity contracts prior to 8/14/82 (also called a pre-TEFRA annuity). These contributions are distributed on a first-in, first-out (FIFO) basis and the owner is not taxed until such contributions are fully recovered.

NOTE: If a pre-TEFRA annuity is exchanged for another annuity, it keeps pre-TEFRA tax treatment described above.

AGGREGATION RULE

There is an aggregation rule which requires that all annuity contracts issued by the same company, to the same owner, in the same calendar year are treated as one annuity contract for purposes of determining the taxable portion of any distributions. EXCEPTIONS TO THE AGGREGATION RULE

The following are exceptions to the aggregation rule:

• Immediate annuities

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• Annuities that are annuitized • Distributions required at the death of the annuity owner • Annuities issued prior to October 21, 1988

Note: If an annuity issued prior to October 21, 1988 is exchanged or transferred to another annuity, the new annuity is subject to aggregation.

TAXATION OF ANNUITIZATION OF NON-QUALIFIED ANNUITIES

When a non-qualified annuity is annuitized, a portion of each annuity payment represents a return of cost-basis and is not taxed, and the remainder of each annuity payment is considered earnings and taxed as ordinary income. The taxable and non-taxable portions of the annuity payments are determined using an exclusion ratio. The exclusion ratio for an annuity is the ratio the cost basis (premiums paid) in the contract bears to the expected return under the contract. Calculating the expected return involves actuarial assumptions if the annuitization is based on a single or joint life. Once the total cost-basis in the non-qualified annuity is recovered using the exclusion ratio, the remaining annuity payments are fully taxable. If the owner dies before the total cost basis is recovered, and annuity payments cease as a result of his death, the un-recovered cost-basis is allowed as a deduction to the owner on their final income-tax return. TAXATION OF ANNUITY UPON DEATH OF THE OWNER

IF OWNER DIES PRIOR TO ANNUITIZATION

GENERAL PROVISIONS

Unlike most other assets, annuities do not receive a step-up in cost-basis at the death of the owner/annuitant; therefore the beneficiary will owe ordinary income tax on all of the earnings in the annuity. If the beneficiary annuitizes the contract, a portion of each annuity payment will be considered a return of cost-basis and not taxable. Determining the taxable portion of each annuity payment was discussed above.

NOTE: Variable annuities issued prior to October 21, 1979 do receive a step-up in cost basis for income tax purposes, and no income tax is payable on the earnings accumulated during the life of the owner when received by the beneficiary.

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ANNUITANT-OWNED ANNUITIES

In most cases the owner of the annuity is also the annuitant. The examples in this section will assume the annuitant and the owner are the same person. SPOUSAL BENEFICIARY

A surviving spouse beneficiary of an annuity can be treated as the new owner. This will allow the surviving spouse of the owner/annuitant to step into the shoes of the deceased owner/annuitant and continue to experience tax-deferred growth until he or she dies. NON-SPOUSAL BENEFICIARY

Unlike a spouse, non-spouse beneficiaries of non-qualified annuities can't assume ownership, but must take the benefits within five years. If the annuity is distributed within five years, taxation of earnings is calculated the same as lump sum (if the annuity is distributed in a lump sum) or as partial withdrawals (if the annuity is distributed in more than one distribution). A non-spousal beneficiary does have the option of annuitizing the annuity; however, they must annuitize the contract within 60 days of the owner/annuitant’s death. In addition the annuity payments must begin within one year after the owner/annuitant dies. This option allows the non-spousal beneficiary to spread the taxation of earnings out over a potentially longer period. If the annuitization option is chosen by the non-spouse beneficiary, taxation of earnings is calculated using the exclusion ratio.

NOTE: If an annuity contract has joint owners, the distribution at death rules are applied upon the first death.

IF OWNER DIES AFTER ANNUITIZATION

If the annuitant dies after annuitization, any remaining payments must be paid out at least as rapidly as under the annuity payout option in effect at the time of the owner's death. Taxability of earnings will be determined using the exclusion ratio described earlier. TAXATION OF OWNERSHIP CHANGES

If the owner(s) add or delete a joint owner, it will be considered a transfer and will trigger taxation of earnings attributable to the transfer of ownership. These transfers of ownership can take the following forms:

• Adding, changing or deleting a joint owner. • Transfer of ownership to another person or entity. • Collateral assignment of the annuity if the annuity was issued after August 13,

1982. If the entire annuity is pledged as collateral, all future earnings within the annuity will be taxed as partial withdrawals in the year credited.

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In addition to taxation of earnings there may be a 10% penalty (assessed on the earnings only) if the owner is younger than 59 ½ . Depending on the nature and amount of the transfer gifts taxes may also be payable. EXCEPTIONS TO TAXATION OF TRANSFERS

The following are exceptions to the taxation of annuity earnings when ownership is transferred:

• Transfers of ownership incident to divorce (qualified domestic court order). • Transfers of ownership between spouses. • Transfers of ownership between an individual and their grantor trust.

1035 EXCHANGES

1035 exchanges refer to a provision in the tax code that allows for the direct transfer of accumulated funds in a life insurance policy, endowment policy, or annuity policy to another life insurance policy, endowment policy, or annuity contract without creating a taxable event. Title 26, Subtitle A, Chapter 1, Sub-chapter O, Part III, Section 1035 states that "no gain or no loss shall be recognized on the exchange" of a life insurance policy for another life insurance policy or endowment or annuity policy...an endowment for another endowment with a maturity no later than the maturity date of the endowment being replaced...an annuity policy for another annuity policy. LIFE INSURANCE TO ANNUITY

Donald purchased a life insurance policy 20 years ago with a death benefit of $100,000, a premium of $1,000 a year, and has accumulated a cash value of $75,000. Donald is now retiring and has adequate life insurance protection provided by another life insurance policy. Donald doesn't need any income at this time, but has decided to purchase an annuity that is paying a 6% guaranteed rate of interest. The cash value of the life insurance policy is $75,000, the premiums paid total $20,000, and if Donald surrenders his policy, the gain of $55,000 would be subject to taxation. The solution is to execute a 1035 Exchange. Donald will fill out a 1035 Exchange form which directs the life insurance company to send the $55,000 cash value directly to the insurance company issuing his annuity policy. Donald never takes constructive receipt of the money (he never has it in his hands or bank account), so he is not taxed. The cost basis of the life insurance policy (his original $20,000 investment) is also transferred into the new annuity contract for future tax calculations.

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ANNUITY TO ANNUITY

1035 exchanges are used between annuity and variable annuity contracts in the same fashion as when transferring from a life insurance policy to an annuity. The most common reason to execute a 1035 exchange between annuities is to earn a higher rate of interest. It is suggested that before a contract owner considers such a 1035 exchange, that he or she discover if any penalties or surrender charges would be imposed before exchanging an existing annuity contract. PARTIAL 1035 EXCHANGE

In an outcome that surprised some, the Tax Court held that a proper Section 1035 exchange had taken place when an annuity holder transferred only a portion of the funds in one annuity to a second newly-issued annuity. This approval of a partial exchange may increase the planning opportunities typically associated with Section 1035 tax-free exchanges. In its opinion, the court examined the regulations for Section 1035, legislative history, and a case dealing with the exchange of Section 403(b) annuities and concluded that there is no requirement stipulating that the entire annuity contract must be exchanged. The court's opinion stated that the only requirements under the applicable regulations are that the contracts be of the same type (e.g., an annuity for an annuity) and that the obligee under the two contracts be the same person. “ONE FOR TWO” 1035

Under Section 1035, exchanges are not actually tax-free, but tax-deferred. The investment in the original contract is carried over to the new contract, so the gain is deferred until payments begin or a withdrawal from the new policy is made. An owner of a deferred annuity requested a ruling on whether the exchange of one annuity contract for two annuity contracts would qualify as a Section 1035 exchange. The two replacement contracts were to be issued by the same insurance company that issued the original annuity contract. The exchange would not have resulted in a change of owner or annuitant. The reason this became an issue is because the language of Section 1035 says that an exchange can be made of "an annuity contract for an annuity contract," which might lead some to believe it means that one contract may be exchanged for only one new contract. In the case at hand, one of the new annuities was to be a variable annuity. The other was to have a guaranteed minimum income feature so that regardless of the performance of the underlying investments of the annuity, a minimum amount will be paid out each month. In its ruling, the IRS pointed out that if two or more annuities were purchased with the same consideration, the annuities would be treated as one annuity contract for income tax

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purposes. The IRS also said that Section 1035 is similar to Section 1031, which governs exchanges of other types of property such as real estate. Under Section 1031, one piece of property may be exchanged for multiple pieces of property on a tax-deferred basis, such as one piece of real estate for two or more. Therefore, the IRS concluded that the proposed exchange would qualify for Section 1035 treatment, and that the two new annuity contracts would be treated as one contract for income tax purposes. Finally, the IRS ruled that any transfer of funds between the two new annuities would not be treated as a taxable distribution from the annuity. The ruling for this is Private Letter Ruling 200243047. PREMATURE WITHDRAWAL PENALTY / NON-QUALIFIED ANNUITIES

The IRS deems withdrawals made from all annuities (non-qualified and qualified) prior to the owner’s age 59 ½ to be premature distributions. Not only are the earnings taxed at ordinary income-tax rates, an additional penalty of 10% is charged on the earnings withdrawn.

No penalties are due on distributions that meet any of the following criteria:

• Made after the owner’s age 59 ½. • Made on or after the death of the owner of the annuity. • Made after the owner becomes disabled. • Made as part of a series of substantially equal periodic payments (not less than

annually) for the life (or life expectancy) of the taxpayer or joints lives (or joint expectancies) of the taxpayer and his or her designated beneficiary.

• Made under a single-premium immediate annuity with a starting date no later than one year from the annuity purchase date.

• Made under certain annuities issued in connection with a structured settlement agreement.

• Annuitization (for the owner's life or life expectancy).

Note: An exchange from a deferred to an immediate annuity does not qualify as an immediate annuity for the purposes of avoiding tax penalty.

OTHER TAX CONSIDERATIONS / NON QUALIFIED ANNUITIES

Since the growth that occurs within a non-qualified annuity is tax-deferred, it is not added to the annuity owner’s income until it is withdrawn from the annuity. This gives rise to a potential benefit of an annuity to certain individuals. The tax-deferred earnings that occur within an annuity do not count towards income thresholds for the purpose of determining if the annuity owner pays federal income taxes on their Social Security benefits. This will be a benefit to an individual (versus other investments without this benefit) if the earnings within the annuity would cause the individual to pay taxes on their Social Security benefits had they occurred outside of an annuity.

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To determine if this will accrue as a benefit to an individual, the agent will need to know the individual’s overall tax situation in considerable detail. Taxation of Social Security benefits is tied to exceeding certain income thresholds, which vary depending on tax-filing status. Below is a brief discussion of how to determine if an individual (or couple) will pay taxes on part of their Social Security benefits. This usually happens only if you have other substantial income (such as wages, self-employment, interest, dividends and other taxable income that must be reported on your tax return) in addition to your benefits. First determine “combined income” as follows

Your adjusted gross income+* Nontaxable interest

+ ½ of your Social Security benefits= Your "combined income"

*Non-taxable income would also include income from municipal bonds.

Then check the “combined income” against the threshold below to see how much (if any) of Social Security benefits are taxable.

If you:

• file a federal tax return as an "individual" and your combined income* is o between $25,000 and $34,000, you may have to pay income tax on up to

50 percent of your benefits. o more than $34,000, up to 85 percent of your benefits may be taxable.

• file a joint return, and you and your spouse have a combined income* that is o between $32,000 and $44,000, you may have to pay income tax on up to

50 percent of your benefits o more than $44,000, up to 85 percent of your benefits may be taxable.

• are married and file a separate tax return, you probably will pay taxes on your benefits.

TAXATION OF QUALIFIED ANNUITIES

A qualified annuity is an annuity that is within a qualified retirement plan. Once an annuity has been placed within a qualified retirement plan it is taxed identically to any other qualified account such as an IRA, 401(k), profit sharing plan or other tax-deferred retirement account. Another way to explain it is that the annuity ceases to be taxed as an annuity and assumes all of the tax characteristics of the qualified retirement plan it is placed within.

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CONTRIBUTIONS TO QUALIFIED ANNUITIES

Almost all contributions to qualified annuities are made with before-tax dollars. Since, by definition, a qualified annuity is within a qualified retirement plan, all contributions are deducted from taxable income. In employer-provided qualified retirement plans, these contributions are actually excluded from taxable income for federal income tax purposes. All growth or earnings that occur within a qualified annuity is tax-deferred and will not be taxed until withdrawn. When withdrawn all taxable amounts from a qualified annuity will be taxed as ordinary income. THE ROTH IRA IS AN EXCEPTION

Due to the tax nature of a ROTH IRA, Qualified annuities within a ROTH do not result in a deduction from taxable income for contributions. The ROTH IRA is also an exception to most of the other tax aspects related to other qualified retirement plans. MINIMUM REQUIRED DISTRIBUTIONS (MRD)

Once the annuity owner has reached age 70 ½ they must begin to distribute the qualified annuity. Generally speaking, the annuitant MUST make the first withdrawal no later than April 1st .of the year following the year they reach age 70 ½. In subsequent years, withdrawals must be made by the end of each calendar year. RETIREMENT PLANS COVERED

If the annuity owner has an IRA, 401(k), 403(b), 457, SEP, or SIMPLE Plan, he or she is also required to begin minimum distributions by age 70½. Roth IRAs are not covered by the MRD rule. MULTIPLE RETIREMENT PLANS

If the annuitant has more than one retirement plan from which minimum required distributions must be made, he or she must calculate the amount required for each plan and make appropriate withdrawals. The actual minimum distribution may be taken from one plan to satisfy the MRDs of all plans. The value used to calculate the MRD is the total value of each plan as of December 31st of the preceding year. IRS PENALTY FOR UNDER-DISTRIBUTION

Failure to make the required minimum distribution by the end of the calendar year results in a penalty equal to 50% of the amount of the distribution. In addition, ordinary income taxes are due on the entire amount, as well.

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CALCULATING THE MRD

Calculating the Minimum Required Distribution (MRD) is easy. The annuitant calculates the account balance as of December 31st of the preceding year and divides it by his or her life expectancy.

ACCOUNT BALANCE Contributions - Include all contributions made in the immediate preceding year for which the calculation is being made. Distributions - When calculating the distribution for the second year only, it is reduced by any distribution made in that year to satisfy the minimum distribution requirement for the first year. The first year distribution year is the year in which the annuity owner reached age 70½.

LIFE EXPECTANCY

Single Life Expectancy - The annuity owner’s life expectancy as set forth by the IRS and declared on a life expectancy table. Joint Life Expectancy - The life expectancy of both the owner and designated beneficiary as set forth by IRS and declared on a life expectancy table. Death of Owner - If the contract owner dies before distributions have begun, the remaining life expectancy of the beneficiary is calculated, as set forth by the IRS and declared on a life expectancy table. QUALIFIED ANNUITY DISTRIBUTIONS PRIOR TO AGE 59½

As discussed in the section on taxation of non-qualified annuities, if the annuity owner makes a withdrawal prior to age 59 ½, the IRS imposes a 10% penalty on the distribution. This penalty is 10% of the part of the distribution that must be included in gross income. Since we are discussing distributions from a qualified annuity, in most cases 100% of the distribution will be included in gross income. This 10% penalty is in addition to any regular income tax on the amount included in gross income. Qualified annuities, because they are funding vehicles for qualified retirement plans, have a wider range of exceptions to this 10% early withdrawal penalty.

NOTE: Don’t confuse the additional exceptions to the 10% early distribution penalty (covered below) available to qualified annuities and assume they also apply to non-qualified annuities.

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EXCEPTIONS TO 10% PENALTY…QUALIFIED ANNUITIES

UNREIMBURSED MEDICAL EXPENSES

Even if younger than age 59½, an owner does not have to pay the 10% tax on amounts withdrawn that are not more than the amount paid for unreimbursed medical expenses during the year of the withdrawal, minus 7.5% of the adjusted gross income for the year of the withdrawal. The annuitant may only take into account unreimbursed medical expenses that would be included in figuring a deduction for medical expenses on Schedule A, Form 1040. Deductions do not have to be itemized to take advantage of this exception to the 10% additional tax. MEDICAL INSURANCE

Even if younger than age 59½, an owner may not have to pay the 10% tax on amounts withdrawn during the year that are not more than the amount paid during the year for medical insurance for themselves, their spouse, and their dependents. Owners will not have to pay the tax on these amounts if all four of the following conditions apply:

1. They lost their jobs. 2. They received unemployment compensation paid under any federal or state law

for 12 consecutive weeks. 3. They made the withdrawals during either the year they received the

unemployment compensation or the following year. 4. They made the withdrawals no later than 60 days after they became re-employed.

DISABILITY

If the owner becomes disabled before reaching age 59½, any amounts withdrawn because of disability are not subject to the 10% additional tax. The owner is considered disabled if they furnish proof that they are unable to do any substantial, gainful activity because of their physical or mental condition. A physician must determine that the condition can be expected to result in death or to be of long, continued, and indefinite duration.

DEATH

If the owner dies before reaching 59 1/2, the assets in the annuity can be distributed to beneficiaries or to the owner’s estate without having to pay the 10% additional tax. However, if an individual inherits a traditional IRA from a deceased spouse and elects to treat it as his or own IRA, any distribution they later receive before reaching age 59 1/2 may be subject to the 10% additional tax.

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HIGHER EDUCATION EXPENSES

Even if the owner has not yet reached 59 1/2, if he or she paid expenses for higher education during the year, part (or all) of any withdrawal may not be subject to the 10% tax on early withdrawals. The part not subject to the tax is generally the amount that is not more than the qualified higher education expenses for the year for education furnished at an eligible educational institution. The education must be for the owner, a spouse, or the children or grandchildren of the owner or the spouse. When determining the amount of the withdrawal that is not subject to the 10% tax, include qualified higher education expenses paid with any of the following types of funds:

• An individual's earnings. • A loan. • A gift. • An inheritance given to either the student or the individual making the

withdrawal. • Personal savings (including savings from a qualified state tuition program).

Do not include expenses paid with any of the following funds: Tax-free distributions from an education IRA.

• Tax-free scholarships, such as a Pell grant. • Tax-free employer-provided educational assistance. • Any tax-free payment (other than a gift, bequest, or devise) due to enrollment at

an eligible educational institution. Qualified higher education expenses. Qualified higher education expenses are tuition, fees, books, supplies, and equipment required for the enrollment or attendance of a student at an eligible educational institution. In addition, if the individual is at least a half-time student, room and board expenses are qualified higher education expenses.

Eligible Educational Institution An eligible educational institution is any college, university, vocational school, or other post-secondary educational institution eligible to participate in the student aid programs administered by the Department of Education. It includes virtually all accredited public, non-profit, and proprietary (privately owned profit-making) post-secondary institutions. The educational institution should be able to tell the annuitant if it is an eligible educational institution.

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FIRST HOME PURCHASE

To qualify for penalty-free withdrawal treatment as a first-time homebuyer distribution, a distribution must meet the following requirements:

• It must be used to pay qualified acquisition costs before the close of the 120th day after the day they received it; or

• It must be used to pay qualified acquisition costs for the main home of a first-time homebuyer who is any of the following:

o The annuity owner. o The annuity owner’s spouse. o The child of the annuity owner or his or her spouse. o The grandchild of the annuity owner or his or her spouse. o The parent or other ancestor of the annuity owner or his or her spouse.

When added to all the prior qualified first-time homebuyer distributions, if any, the total distributions cannot be more than $10,000. If both husband and wife are first-time homebuyers, they may each withdraw up to $10,000, penalty-free, for a first home.

Qualified Acquisition Costs Qualified acquisition costs include the costs of buying, building, or rebuilding a home and any usual or reasonable settlement, financing, or other closing costs.

First-Time Homebuyer

A first-time homebuyer is, generally, any individual (and his or her spouse, if married) who had no present ownership interest in a main home during the two-year period ending on the date the individual acquires the main home to which these rules apply.

Date of Acquisition

The date of acquisition is the date that the first-time homebuyer enters into a binding contract to buy the main home to which these rules apply or the building or rebuilding of the main home to which these rules apply begins. AVOIDANCE OF THE PRE 59 1/2 DISTRIBUTION PENALTY

If an annuity owner adheres strictly to one of three withdrawal methods of which the IRS approves, he or she may make withdrawals prior to age 59 1/2 and avoid the Premature Distribution Penalty Tax. The annuitant may receive distributions that are part of a series of substantially equal payments over the annuitant’s lifetime (or life expectancy), or over the lifetimes (or joint life expectancies) of the annuitant and the beneficiary, without having to pay the 10% additional tax, even if such distributions are received before the annuitant reaches age 59 1/2.

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The annuitant must use an IRS-approved distribution method and at least one distribution must be received annually for this exception to apply. One IRA-approved method is known as the "life expectancy method," and unlike the purposes used for minimum distributions, this method results in the exact amount required, not the minimum amount. The payments under this exception must continue for at least five years, or until the annuitant reach age 59 1/2, whichever is the longer period. This five-year rule does not apply if a change from an approved distribution method is made because of the death or disability of the annuity owner. For example, if the annuitant received a lump-sum distribution of the balance in an annuity before the end of the required period for the annuity distributions, and they did not receive it because of disability, the annuitant would be subject to the 10% additional tax. The tax would apply to the lump-sum distribution and all previous distributions made under the exception rule. There are two other IRS-approved distribution methods. They are generally referred to as the amortization method and the annuity factor method. These two methods are complex and require the assistance of a tax professional. For more information about these methods, see IRS Notice 89-25 in Internal Revenue Cumulative Bulletin 1989-1.

PRIMARY USES OF ANNUITIES

TAX-DEFERRED GROWTH VS TAXABLE OR TAX-FREE GROWTH

Earlier in the section on annuity taxation we learned that the money deposited into an annuity may earn interest, receive dividend income, or earn capital gain distributions (collectively referred to as earnings). These earnings--unlike earnings in a savings account, mutual fund, or certificate of deposit--are not taxed in the year in which they are earned. Thus the earnings continue to grow and compound, tax-deferred, until withdrawn. We learned some of the restrictions in the tax code associated with the benefit of tax-deferred growth. We also learned how, when and to whom these earnings are ultimately considered taxable income. The value of difference in taxable growth versus tax-deferred growth will vary from one individual to another based on a number of factors including their current marginal income tax bracket as well as their anticipated retirement tax bracket. While the value of tax deferral will vary from one to another most agree that tax deferral is a valuable tool for wealth accumulation. The longer one has to experience tax-deferred growth the greater the potential benefit they can receive.

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TAX-FREE GROWTH

There are very few places where one can experience tax-free growth within the current tax structure in the United States. Some Municipal Bonds are exempt from Federal and State income taxes, and the interest paid by these instruments is priced with the this advantage in mind. As with tax deferral, the value of tax-free growth will vary from one taxpayer to another based on a number of factors. Another place where tax-free growth can be obtained is through the use of a Roth IRA. Earlier in this chapter we learned that the Roth IRA is an exception among qualified plans in that it does not allow a deduction from current taxable income for contributions but can provide tax-free income from that point forward. The Roth IRA is also an exception among qualified retirement plans in that it is exempt from the required minimum distribution requirements. The intent here is not to write a section on the Roth IRA, but to point out that many annuities can be placed within a Roth IRA and most annuity issuers offer an annuity that can be used inside of a Roth. PRIMARY USES OF ANNUITIES

GUARANTEED LIFETIME STREAM OF INCOME Another popular use of annuities is to guarantee the owner a stream of income they can’t outlive. The owner can annuitize the annuity under one of the annuity payout options and enjoy a pre-defined stream of income. As we learned earlier in a deferred annuity, annuitization often occurs many years after purchase when the owner has accumulated sufficient values to produce a meaningful income stream. With a single-premium immediate annuity the owner is likely repositioning monies that were accumulated in some investment other than an annuity and now wishes a guaranteed stream of income upon retirement. ANNUITIZATION SETTLEMENT OPTIONS

Settlement options are the methods by which an insurance company pays annuity proceeds to the annuitant, contract owner, or beneficiary(ies). Annuities offer a variety of options to provide annuitants with long-term income payments. Regardless of the type of settlement option, the annuitant may choose to receive payments monthly, quarterly, semi-annually, or annually. In addition to the settlement options listed below, many annuities offer guaranteed income streams without the need for annuitization.

LIFE ONLY

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The life only option provides for payments that continue throughout the life of the annuitant. The annuitant cannot outlive income. Upon the annuitant’s death, however, payments cease, regardless of the length of time payment have been made.

ADVANTAGES • Results in the highest payout among the life assumptions. • Provides an income stream for life of annuitant.

DISADVANTAGES

• Does not offer a refund or guarantee to the heirs if the annuitant dies before receiving all of the initial premium back.

• No income stream to spouse if married.

LIFE ONLY WITH GUARANTEED MINIMUM OPTION OR REFUND

The annuitant receives payments that continue for life. If the annuitant dies before the initial investment in the annuity has been repaid, the balance of the initial investment will be paid to the beneficiary(ies).

ADVANTAGES • Guarantees that if the annuitant dies before receiving at least their initial

investment in the annuity the heirs will receive the balance. • Provides an income stream for life.

DISADVANTAGES

• Pays a smaller income to the annuitant than life only due to the cost of the minimum guarantee to the heirs.

• No income stream to spouse if married.

LIFE WITH PERIOD CERTAIN Life and period certain means payments will continue for the rest of the annuitant’s life but for no less than the stated number of years—even if the annuitant dies. If the annuitant dies before the end of the period certain, the beneficiary(ies) continue to receive the payments for the balance of the period certain.

ADVANTAGES • Provides an income stream for life • The period certain guarantee supports a larger amount to the heirs than the refund

or guaranteed minimum should the annuitant die early. Also potentially would provide a benefit to the heirs when the refund wouldn’t.

DISADVANTAGES

• Pays a smaller income amount to the annuitant due to the increased costs of the period certain guarantee.

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• No income stream to spouse if married.

JOINT AND SURVIVOR

When a joint and survivor annuity contract is issued on a couple (usually and husband and wife), or if the beneficiary opts for a joint and survivor payout, the contract provides a payout for as long as either of the two annuitants/beneficiaries is alive. The amount of each payment is usually less than if it were based on a single individual. They may choose to have payments remain the same or decrease after the death of the first annuitant. For example, after the first annuitant/beneficiary dies, they may choose to have payments reduce to two-thirds of the amount paid while both annuitants were alive. This is called a joint and two-thirds annuity.

ADVANTAGES • Provides an income stream for life of annuitant and/or spouse. • Most companies allow a reduced survivor benefit (as in the 2/3 example) to

minimize impact on income while both live.

DISADVANTAGES • Pays a smaller income amount than would any of the other life assumption

options. • If spouse predeceases annuitant, annuitant is stuck at lower income level.

PERIOD CERTAIN ONLY Period certain means that income payments will be made over a specified number of years chosen by the annuitant. Payments will continue for the duration of the period certain and at the end of that term, will cease. If the annuitant dies before the end of the stated number of years, the beneficiary(ies) continue to receive payments for the balance of the period certain. Most annuity contracts only allow annuitization over a limited choice of certain periods ( 3 yrs, 5yrs, 10 yrs etc), however; some annuity contracts allow the annuity owner to specify a dollar amount of the periodic annuity payment and then “back in” to the length of the period certain.

ADVANTAGES • Usually provides a larger income stream than any of the life assumption options.

Exceptions would be if period certain was longer than life expectancy of annuitant.

• Amount of income needed is driver for the options and the amount paid under period certain meets short-term income goals better than a life assumption option.

DISADVANTAGES

• No life assumption, therefore annuitant and/or spouse could outlive income stream.

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LONG-TERM RETIREMENT ACCUMULATION One of the most common uses for an annuity is long-term saving for retirement. Since the annuity grows tax-deferred, the annuity owner benefits from the lon- term deferral of taxes on the growth inside the annuity. This is true whether the annuity is qualified or non-qualified. When utilizing an annuity for retirement the annuity owner makes a long-term commitment to save for retirement and understands that it takes consistent saving over an extended period to build retirement wealth. Long term can be defined a number of ways, but usually is interpreted to mean at least 5 to 10 years. When selling an annuity the term “long term” should be at least equal in length to the duration of the surrender charge period of the annuity being recommended.

POTENTIAL TO AVOID PROBATE Most states exempt from probate an intangible personal property with an operative beneficiary designation. Life insurance death benefits and proceeds from annuities are exempt from probate in most states, provided the beneficiary designation is operative. An operative beneficiary designation is where the named beneficiary is a valid person or trust, can be uniquely determined from the contract (life policy or annuity), and is unambiguous. If the primary beneficiary has predeceased the owner of the life policy or annuity, the beneficiary designation is still operative provided there is a secondary beneficiary designation.

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Chapter 2 - Review Questions (Answers are in the back of the text)

1. Which of the following describes a premature distribution?

(a) Selecting annuitization prior to age 70 ½ (b) Withdrawing funds from an annuity before the annuitant’s age 59 ½ (c) A settlement option (d) A non-forfeiture option

2. Withdrawals from a qualified annuity may be postponed until what age?

(a) 55 (b) 59 ½ (c) 65 (d) 70 ½

3. Failure to make the required minimum distributions from an annuity by the annuitant’s

age 70 ½ results in a penalty of what amount?

(a) 10% (b) 15% (c) 38% (d) 50%

4. MRD is an acronym for which of the following?

(a) Minimum Required Deposit (b) Maximum Required Deposit (c) Minimum Required Distribution (d) Maximum Required Distribution

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Chapter 3 NAIC ANNUITY SUITABILITY MODEL

NAIC SUITABILITY IN ANNUITY TRANSACTIONS MODEL REGULATION

NOTE: This section covers the current status of the NAIC Suitability in Annuity Transactions Model Regulation. This Model Regulation can be viewed as a template to be used in drafting the law to be passed at the state level. In several sections there are blanks where reference to state laws will be inserted and/or choice will be made by state legislators. The NAIC will be publishing best practices for additional guidance to insurers and producers to use to comply with Section 6. While all sections of this Model Regulation are important, Section 6 contains the duties of the insurer and producer under this regulation and should be reviewed carefully.

SECTION 1 PURPOSE

A. The purpose of this regulation is to require insurers to establish a system to supervise recommendations and to set forth standards and procedures for recommendations to consumers that result in a transaction involving annuity products so that unsuitable sales are deterred and the insurance needs and financial objectives of consumers at the time of the transaction are appropriately addresses. B. Nothing herein shall be construed to create or imply a private cause of action for a violation of this regulation. SECTION 2. SCOPE

This regulation shall apply to any recommendation to purchase, exchange or replace an annuity made to a consumer by an insurance producer, or an insurer where no producer is involved, that results in the purchase, exchange or replacement recommended. SECTION 3. AUTHORITY

This regulation is issued under the authority of [insert reference to state enabling

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legislation]. SECTION 4. EXEMPTIONS

Unless otherwise specifically included, this regulation shall not apply to recommendations involving: A. Direct response solicitations by insurers where there is no recommendation based on information collected from the consumer pursuant to this regulation; B. Contracts used to fund:

(1) Any of the following, unless there is a recommendation to an individual plan participant regarding an annuity, in which case this regulation does apply with respect to the recommendation:

(a) An employee pension or welfare benefit plan that is covered by the Employee Retirement and Income Security Act (ERISA); (b) A plan described by sections 401(a), 401(k), 403(b), 408(k) or 408(p) of the Internal Revenue Code (IRC), as amended, if established or maintained by an employer; (c) A government or church plan defined in section 414 of the IRC, a government or church welfare benefit plan, or a deferred compensation plan of a state or local government or tax exempt organization under section 457 of the IRC; (d) A nonqualified deferred compensation arrangement established or maintained by an employer or plan sponsor;

(2) Settlements of or assumptions of liabilities associated with personal injury litigation or any dispute or claim resolution process; or (3) Formal prepaid funeral contracts.

NOTE: When adopted by states this section often does not exempt employer-provided retirement plans where individual annuities are used to fund the plan and/or where the plan participants have a choice of two or more annuity vendors within the plan.

SECTION 5. DEFINITIONS

A. “Annuity” means an annuity that is an insurance product under State law that is individually solicited, whether the product is classified as an individual or group annuity.

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B. “Continuing education credit” or “CE credit” means one continuing education credit as defined in [insert reference in State law or regulations governing producer continuing education course approval]. C. “Continuing education provider” or “CE provider” means an individual or entity that is approved to offer continuing education courses pursuant to [insert reference in State law or regulations governing producer continuing education course approval]. D. “FINRA” means the Financial Industry Regulatory Authority or a succeeding agency. E. “Insurer” means a company required to be licensed under the laws of this state to provide insurance products, including annuities. F. “Insurance producer” means a person required to be licensed under the laws of this state to sell, solicit or negotiate insurance, including annuities. G. “Recommendation” means advice provided by an insurance producer, or an insurer where no producer is involved, to an individual consumer that results in a purchase, exchange or replacement of an annuity in accordance with that advice. H. “Suitability information” means information that is reasonably appropriate to determine the suitability of a recommendation, including the following:

(1) Age; (2) Annual income; (3) Financial situation and needs, including the financial resources used for the funding of the annuity; (4) Financial experience; (5) Financial objectives; (6) Intended use of the annuity; (7) Financial time horizon; (8) Existing assets, including investment and life insurance holdings; (9) Liquidity needs; (10) Liquid net worth; (11) Risk tolerance; and

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(12) Tax status. SECTION 6. DUTIES OF INSURERS AND OF INSURANCE PRODUCERS

A. In recommending to a consumer the purchase of an annuity or the exchange of an annuity that results in another insurance transaction or series of insurance transactions, the insurance producer, or the insurer where no producer is involved, shall have reasonable grounds for believing that the recommendation is suitable for the consumer on the basis of the facts disclosed by the consumer as to his or her investments and other insurance products and as to his or her financial situation and needs, including the consumer’s suitability information, and that there is a reasonable basis to believe all of the following:

(1) The consumer has been reasonably informed, in general terms, of various features of the annuity, such as the potential surrender period and surrender charge, potential tax penalty if the consumer sells, exchanges, surrenders or annuitizes the annuity, mortality and expense fees, investment advisory fees, potential charges for and features of riders, limitations on interest returns; insurance and investment components and market risk; (2) The consumer would benefit from the purchase of the annuity certain features of the annuity, such as tax-deferred growth, annuitization or death or living benefit; (3) The particular annuity as a whole, the underlying subaccounts to which funds are allocated at the time of purchase or exchange of the annuity, and riders and similar product enhancements, if any, are suitable (and in the case of an exchange or replacement, the transaction as a whole is suitable) for the particular consumer based on his or her suitability information; and (4) In the case of an exchange or replacement of an annuity, the exchange or replacement is suitable including taking into consideration whether:

(a) The consumer will incur a surrender charge, be subject to the commencement of a new surrender period, lose existing benefits (such as death, living or other contractual benefits), or be subject to increased fees, investment advisory fees or charges for riders and similar product enhancements; (b) The consumer would benefit from product enhancements and improvements; and (c) The consumer has had another annuity exchange or replacement and, in particular, an exchange or replacement within the preceding 36 months.

B. Prior to the execution of a purchase or exchange of an annuity resulting from a recommendation, an insurance producer, or an insurer where no producer is involved, shall make reasonable efforts to obtain the consumer’s suitability information

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C. An insurer is ultimately responsible for compliance with this regulation. If a violation occurs, either because of the action or inaction of the insurer or its insurance producer, the insurer is responsible for taking appropriate corrective action, including, but not limited to, canceling a transaction that is not suitable, and is subject to sanctions and penalties, subject to section 8 of this regulation. D. Except as permitted under subsection E, an insurer shall not issue an annuity recommended to a consumer unless there is a reasonable basis to believe the annuity is suitable based on the consumer’s suitability information. The penalty for a violation of this subsection is subject to section 8C of this regulation. E

(1) Except as provided under paragraph (2) of this subsection, neither an insurance producer, nor an insurer where no producer is involved, shall have any obligation to a consumer under Subsection A or D related to any annuity transaction if a consumer:

(a) Refuses to provide relevant information requested by the insurer or insurance producer, or decided to enter into an annuity transaction that is not based on a recommendation of the insurer or insurance producer, but there is a reasonable basis to believe the annuity transaction is suitable; or (b) Fails to provide complete or accurate information

(2) An insurer or insurance producer’s recommendation subject to Paragraph (1) shall be reasonable under all the circumstances actually known to the insurer or insurance producer at the time of the recommendation. (3) Where the customer refuses to provide suitability information, the insurance producer, or an insurer where no insurance producer is involved, must provide the customer with an explanation of the purpose of requesting the suitability information and the potential repercussions of not providing the suitability information.

F. An insurance producer or, where no insurance producer is involved, the responsible insurer representative, shall at the time of sale:

(1) Make a record of any recommendation subject to section 6A of this regulation; (2) Obtain a customer signed statement documenting a customer’s refusal to provide suitability information, if any; and (3) Obtain a customer signed statement acknowledging that an annuity transaction is not recommended if a customer decides to enter into an annuity transaction that is not based on the insurer producer’s or insurer’s recommendation.

G

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(1) An insurer shall establish a supervision system that is reasonably designed to achieve the insurer’s and its insurance producers compliance with this regulation, including, but not limited to, the following:

(a) The insurer shall maintain reasonable procedures to inform its insurance producers of the requirements of this regulation and shall incorporate the requirements of this regulation into relevant insurance producer training manuals; (b) The insurer shall establish standards for insurance producer product training and shall maintain reasonable procedures to require its insurance producers to comply with the requirements of section 7 of this regulation; (c) The insurer shall provide product-specific training and training materials which explain all material features of its annuity products to its insurance producers; (d) The insurer shall maintain reasonable procedures to confirm consumer suitability information that supports a recommendation to the extent reasonably appropriate to identify, and to deter, insurance producer submission of inaccurate information; (e)

(i) The insurer shall maintain reasonable procedures for review of each recommendation, including each insurance producer recommendation, that are reasonably designed to ensure that there is a reasonable basis to determine that a recommendation is suitable. An insurer’s procedures under this paragraph may be accomplished electronically applying a system of selection criteria to identify selected recommendations for review that is reasonably designed to ensure that there is a reasonable basis to determine that recommendations are suitable. Such an electronic system may be designed to require staff review only of those transactions identified for staff review by the selection criteria. (ii) Nothing in this subparagraph:

(I) Restricts the FINRA member broker-dealer safe harbor provided under paragraph (2); or (II) Prevents an insurer from contracting as provided under paragraph (3) for performance of the procedures required under this subparagraph;

(f) The insurer shall maintain reasonable procedures to detect recommendations that are not suitable. This may include, but is not limited to, systematic customer surveys, interviews, confirmation letters and programs of internal monitoring;

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(g) The insurer shall maintain reasonable procedures for examination of its insurance producers and their affiliated insurance agencies at reasonable periodic intervals. The examination shall be reasonably designed to assist in detecting and preventing violations of this regulation. Nothing in this paragraph prohibits an insurer from accepting an examination conducted, and report certified, by an independent qualified firm or contracting under paragraph (3) for performance of the examination. Any such examination shall comply with the requirements of this subparagraph; and (h) The insurer shall annually provide a report to senior management, including to the senior manager responsible for audit functions, which details a review, with appropriate testing, reasonably designed to determine the effectiveness of the supervision system, the exceptions found, and corrective action recommended, if any.

(2)

(a) A FINRA member broker-dealer supervision system that complies with FINRA suitability rules shall satisfy the insurer’s supervision requirements under subsection G (b) An insurer shall:

(i) Monitor the FINRA member broker-dealer, using information collected in the normal course of the insurer’s business; and (ii) Provide to the FINRA member broker-dealer information and reports that are reasonably appropriate to assist the FINRA member broker-dealer to maintain its supervision system.

(3)

(a) Nothing in this subsection restricts an insurer from contracting for performance of a function required under this subsection. An insurer is subject to, and is required to comply with this subsection G regardless of whether the insurer contracts for performance of a function and regardless of the insurer’s compliance with subparagraph (b) of this paragraph. (b) An insurer’s supervision system under paragraph (1) shall include reasonable supervision of contractual performance under this subsection. This includes, but is not limited to, the following:

(i) Reasonable monitoring and, as appropriate, audits to assure that the contracted function is properly performed; and (ii) Annually obtaining a certification from a senior manager who has responsibility for the contracted function that the manager has a reasonable basis to represent, and does represent, that the function is properly

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performed.

(4) An insurer is not required to include in its system of supervision an insurance producer’s recommendations to consumers of products other than the annuities offered by the insurer.

H. An insurance producer shall not dissuade, or attempt to dissuade, a consumer from:

(1) Truthfully responding to an insurer’s request for confirmation of suitability information; (2) Filing a complaint; or (3) Cooperating with the investigation of a complaint.

I. A registered representative recommendation of an annuity that is a security that complies with the FINRA rules pertaining to suitability shall satisfy the requirements under this section for the recommendation of annuities. However, nothing in this subsection shall limit the insurance commissioner’s ability to enforce the provisions of this regulation. SECTION 7. INSURANCE PRODUCER TRAINING

A. An insurance producer shall not solicit the sale of an annuity product unless the insurance producer has adequate knowledge of the product to recommend the annuity and the insurance producer is in compliance with the insurer’s standards for product training. An insurance producer may rely on insurer-provided product-specific training standards and materials to comply with this subsection. B.

(1) An insurance producer who engages in the sale of annuity products shall complete a one-time four (4) credit training course approved by the department of insurance and provided by the department of insurance-approved education provider. (2) The minimum length of the training required under this subsection shall be sufficient to qualify for at least four (4) CE credits, but may be longer. (3) The training required under this subsection shall include information on the following topics:

(a) The types of annuities and various classifications of annuities; (b) Identification of the parties to an annuity; (c) How fixed, variable and indexed annuity contract provisions affect consumers;

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(d) The application of income taxation of qualified and non-qualified annuities; (e) The primary uses of annuities; and (f) Appropriate sales practices, replacement and disclosure requirements.

(4) Providers of courses intended to comply with this subsection shall cover all topics listed in the prescribed outline and shall not present any marketing information or provide training on sales techniques or provide specific information about a particular insurer’s products. Additional topics may be offered in conjunction with and in addition to the required outline. (5) A provider of an annuity training course intended to comply with this subsection shall register as a CE provider in this State and comply with the rules and guidelines applicable to insurance producer continuing education courses as set forth in [insert reference to State law or regulations governing producer continuing education course approval]. (6) Annuity training courses may be conducted and completed by classroom or self-study methods in accordance with [insert reference to State law or regulations governing producer continuing education course approval]. (7) Providers of annuity training shall comply with the reporting requirements and shall issue certificates of completion in accordance with [insert reference to State law or regulations governing to producer continuing education course approval]. (8) The satisfaction of the training requirements of another State that are substantially similar to the provisions of this subsection shall be deemed to satisfy the training requirements of this subsection in this State. (9) Insurance producers who hold a life insurance line of authority on the effective date of this regulation shall complete the requirements of this subsection within six (6) months after the effective date of this regulation. Individuals who obtain a life insurance line of authority on or after the effective date of this regulation may not engage in the sale of annuities until the annuity training course required under this subsection has been completed. (10) An insurer shall verify that an insurance producer has completed the annuity training course required under this subsection before allowing the producer to sell an annuity product for that insurer. An insurer may satisfy its responsibility under this subsection by obtaining certificates of completion of the training course or obtaining reports provided by commissioner-sponsored database systems or vendors or from a reasonably reliable commercial database vendor that has a reporting arrangement with approved insurance education providers.

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SECTION 8. MITIGATION OF RESPONSIBILITY

A. The commissioner may order:

(1) An insurer to take reasonably appropriate corrective action for any consumer harmed by the insurer’s, or by its insurance producer’s, violation of this regulation; (2) An insurance producer to take reasonably appropriate corrective action for any consumer harmed by the insurance producer’s violation of this regulation; and (3) A general agency or independent agency that employs or contracts with an insurance producer to sell, or solicit the sale, of annuities to consumers, to take reasonably appropriate corrective action for any consumer harmed by the insurance producer’s violation of this regulation.

B. Any applicable penalty under [insert statutory citation] for a violation of section 6A, B, E or F of this regulation may be reduced or eliminated [, according to a schedule adopted by the commissioner,] if corrective action for the consumer was taken promptly after a violation was discovered. C. Any applicable penalty under [insert statutory citation] for an insurer’s violation of section 6D of this regulation may be reduced or eliminated [, according to a schedule adopted by the commissioner,] if:

(1) Corrective action for the consumer is taken promptly after a violation is discovered; and (2) The insurer reviewed the recommendation and approved issuance of the annuity after consideration of the customer’s suitability information as required under section 6G(1)(e) of this regulation, and the documentation received by the insurer reasonably led the insurer to believe that the sale was suitable for the customer at the time the annuity issued. The review and approval may be made applying selection criteria as permitted under section 6G(1)(e) of this regulation.

D. The powers vested in the commissioner through this regulation shall be additional to any other powers vested in him or her under law. SECTION 9. [OPTIONAL] RECORDKEEPING

A. Insurers, general agents, independent agencies and insurance producers shall maintain or be able to make available to the commissioner records of the information collected from the consumer and other information used in making the recommendations that were the basis for insurance transactions for [insert number] years after the insurance transaction is completed by the insurer. An insurer is permitted, but shall not be required, to maintain documentation on behalf of an insurance producer.

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B. Records required to be maintained by this regulation may be maintained in paper, photographic, micro-process, magnetic, mechanical or electronic media or by any process that accurately reproduces the actual document. SECTION 10. EFFECTIVE DATE

The amendments to this regulation shall take effect six (6) months after the date the regulation is adopted or on January 1, 2011, whichever is later.

DETERMINING CLIENT SUITABILITY So far we have learned that as a producer selling annuities of any kind, we must obtain information from the prospective customer to ascertain suitability. We have also reviewed the NAIC Annuity Suitability Model Regulation. These regulations spell out the duties of insurers and producers relative to recommendations to consumers for annuity transactions (purchase or exchange). Before an annuity transaction is recommended the agent or the insurer (if no agent is involved) must document, in writing, a reasonable basis for making the recommendation. As we saw earlier in this chapter, The NAIC Suitability in Annuity Transactions Model Regulation defines twelve categories of “Suitability Information” that should be collected to determine the suitability of a recommended annuity transaction. Most of the suitability forms that have been and will be developed revolve around these twelve categories of information. With this in mind we offer the following chapter as a primer to the producer to consider. In the following pages we cover many elements of a consumer’s lifestyle that can affect the suitability of an annuity transaction. If the producer transacts business in a state with a mandated form or transacts business for an insurer with their own information gathering requirements, we recommend they follow those requirements. HOW ANNUITY PROVISIONS AFFECT CONSUMERS

As we cover the different categories of information to be gathered from the prospective annuity owner, we will attempt to explain why this information is important and how provisions within an annuity contract can affect a consumer based on differing scenarios. Since annuities impose surrender charges the current and future liquid resources and needs of the consumer should be a major consideration in determining annuity suitability. A big issue with annuity sales is overselling an annuity. Overselling is taking a situation where an annuity makes sense for the consumer but the agent recommends that too much

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of their assets be put into an annuity. When an annuity is oversold the consumer often finds themselves needing cash for some reason and the only place they can turn (short of borrowing) is the annuity which may still be within the surrender charge period. While most regulations affecting annuity suitability do not require all of the below information to be collected, we list many facets of the consumers current situation that can have a bearing on suitability and provide a short narrative of how and why it is important. Whether or not the producer decides to embrace all of the suggestions in this chapter, It is certain that the more relevant information one obtains from the consumer the more likely one is to consistently make suitable recommendations.

PERSONAL INFORMATION Personal Information This category includes information such as: name, age, sex, address, marital status and dependents and their ages. This information should be collected for all parties to the annuity.

CONSUMER FINANCIAL STATUS

Current financial situation: The consumer’s current financial situation includes information related to their current assets, income-tax circumstances, liquidity needs, and resources. ASSETS - INVESTMENTS AND LIFE INSURANCE

Existing assets: Information should be collected about all of their investments. For each asset the type of asset, value, original purchase date, intended use, tax status (qualified or non-qualified), type of ownership (single, joint, trust), and current income (if any) provided by the asset.

ENDOWMENTS

Endowments: If the consumer is the beneficiary of an endowment the start date (or maturity/endowment date) and form and amount of payment will be important to determining their future financial outlook. Conversely, if the consumer wishes to fund an endowment for the benefit of others, the desired contribution amount and date of contribution will need to be considered in their overall future financial considerations.

ANNUAL INCOME

Applicant's annual income: The consumer’s income and sources of income need to be determined. Some retirement plans and financial institutions will withhold estimated taxes as a convenience for the income recipient. If the

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income stream has already had estimated taxes withheld then the agent needs to know if the amounts withheld have been adequate in past years. If in the past the consumer has been required to pay additional taxes at year end this will be evidence of an annual need for liquidity. If no taxes are withheld from some or all of the consumer’s income streams then the need for liquidity at tax time will be greater. The nature of the income is also important as well as past history of the income stream versus inflation. If the income tends to fluctuate this also needs to be known as well as a range of the expected fluctuation. If an income stream has a known ending point that is also important. For example, the consumer might have sold a piece of real estate and owner financed the sale but the payments will end in 5 years because the property will be paid off. If the client is still working and producing income the intended retirement date is important as well as any predicted changes in future earnings.

LIQUID NET WORTH While some of the recommendation below are not specifically required by suitability laws, we submit them as additional measures to forecast future needs for liquidity and explore areas that may result in future needs for liquidity that may not be readily apparent to most consumers. Following these recommendations may ultimately result in a smaller annuity sale but should also result in a more thorough analysis of potential future needs for liquidity. The consumer’s liquid net worth should represent only the net value of assets after being converted to cash. Assets such as real estate (including the principal residence) should not be included in a liquid net-worth calculation because of the speculative nature of the sale of the real estate. Assets such as automobiles and household belongings should not be included as liquid assets, even if they could be sold with relative ease, because they are utilized in the consumer’s daily life and are not likely to be sold. If liquidation of an asset involves imposition of a surrender charge or other penalty, only the net value after imposition of the surrender charge or penalty should be considered.

LIQUIDITY NEEDS If an asset is exposed to market risks, the future amount available for liquidity is difficult to gauge. Additionally, if the consumer is not yet 59 ½ years old, the qualified retirement assets should not be counted as liquid due to the 10% early withdrawal penalty. Another consideration is the required minimum distribution requirement at age 70 ½. If the consumer is subject to this requirement, they should have sufficient retirement assets available for liquidation without penalty, surrender charge, or market risk to comply with the required distributions. Laddering of assets over time is a good strategy for

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providing future liquidity. It involves projecting liquidity needs into the future and determining which assets will provide that liquidity stream without penalty, surrender charge, or potential market loss.

AFFECT OF IRS EARLY WITHDRAWAL PENALTY ON LIQUIDITY NEEDS

If the one of the consumers is under 59 ½ their qualified retirement assets or any annuity should not be counted as liquid due to the 10% early withdrawal penalty imposed by the IRS on withdrawals from retirement plans or annuities prior to age 59 1/2. On the other side of this issue, if the consumer is already under the required minimum distribution requirement they should have sufficient retirement assets in a position to be liquidated without penalty, surrender charge, or market risk to comply with the required distributions. Laddering of assets is a good strategy to provide future liquidity and involves projecting liquidity needs into the future and determining which assets will provide that liquidity stream without penalty, surrender charge or potential market loss.

TAX STATUS

Tax status: The insurer and/or agent need to know the consumers tax filing status (married, head of household, single, qualifying widow, etc.) as well as any taxes in arrears. If, because of how the consumer receives their income, they end up having to pay taxes at the end of the year, this is important in that it affects liquidity needs.

Consumer Financial Objectives The insurer or agent needs to get information from the consumer(s) about their investment objectives. Often the consumer needs to be asked numerous follow up questions for them to fully articulate their investment objectives. The timing and amount of future access to the intended funds should be determined to the best of the client’s ability. This is a good time to question about the need for and existence of an emergency fund. It sometimes helps if the insurance agent repeats to the client what they think they heard as the stated investment objective. This gives the consumer an additional chance to sharpen their definition of their goals.

CONSUMER’S RISK TOLERANCE

Many insurers use some form of questionnaire designed to help determine risk tolerance. This completed questionnaire is often retained by the insurer to show that an attempt was made to determine risk tolerance. Generally speaking, the more financial risk the product would pose to the client, the more likely the insurer is to require a risk tolerance questionnaire. Many of these suitability questionnaires are structured so that they can be scored in the field by the agent and result in a numerical score that determines if the consumer’s risk tolerance is

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within the range suitable for the product being recommended. When there is more than one person purchasing the annuity (such as husband and wife) the risk tolerance of both should be determined. INTENDED USE OF ANNUITY

Intended use of the annuity: The stated goal that the consumer hopes to accomplish by purchasing or exchanging the annuity should be determined. If the consumer states as their goal “to guarantee a stream of income that I can’t outlive” then it appears that the annuity is designed to meet that goal. If, however, the consumer has non-qualified funds and states that their goal is “to invest this money and let it grow and pass to my children upon my death” (which is classified as a wealth transfer goal) then the annuity might not be the best answer. Since annuities are one of the few assets that do not “step up” in cost basis for federal income-tax purposes, the client needs to be informed of this fact. While the annuity will grow tax-deferred during the consumer’s life, upon their death all of the growth in the annuity (that was tax-deferred during accumulation) will be taxed when withdrawn as ordinary income.

SOURCE OF FUNDS USED TO PURCHASE THE ANNUITY

Source of funds to be used for purchase of annuities: The insurer or insurance agent should determine the source of the funds used to purchase the annuity. If the source of funds would require liquidation and has unrealized capital gains that would be realized as part of the transaction, the agent should disclose to the consumer that it will be a taxable event when they liquidate the asset to provide the funds to purchase the annuity. Unless the insurance agent is also a CPA, they should not give specific tax advice to the consumer, nor should they attempt to estimate the amount of taxes that would be due. Many assets incur fees, penalties, surrender charges and/or tax consequences when liquidated, surrendered, cancelled, or otherwise converted to cash. The consumer needs to understand these additional costs to the overall transaction.

ANTICIPATED RETIREMENT AGE

Retirement age preference: Retirement is not always a clear line in the sand. Often retirement is partial and involves re-hire-ment, where the retiree seeks some form of part-time employment to supplement their retirement. The retirement date desired by the consumer will obviously affect their retirement planning and liquidity needs. The anticipated retirement lifestyle and debt structure (if any) at the time of retirement will help determine the income needs at retirement.

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CONSUMER’S FINANCIAL EXPERIENCE The ability of the consumer to understand complex financial products will be affected by their level of financial experience. The producer needs to ascertain this level of experience and should never assume that the consumer understands a product.

FINANCIAL CONCERNS

FUTURE FINANCIAL CONSIDERATIONS This category of information can involve many consumer goals. It could involve the future purchase of a recreation item (RV or boat), the purchase of real estate, the funding of education for loved ones, providing for potential long term care costs, cessation of employment, future cessation of a current stream of income, caring for a dependent (which could include a parent, child or grandchild), wealth transfer, or many other goals. The time horizon and amount needed to satisfy each of these future considerations will affect future needs for asset growth and liquidity.

SOCIAL SECURITY BENEFITS The beginning date and amount of Social Security retirement benefits should be factored into the overall retirement plan of the consumer. This is facilitated by the fact that each Social Security taxpayer receives an annual report that estimates their retirement benefits. Of course, if they are already receiving Social Security retirement benefits, those amounts would have been captured under Annual Income earlier in the information gathering process.

RETIREMENT PLAN DISTRIBUTIONS If the consumer is anticipating any retirement plan distributions in the future, those amounts need to be estimated as to amount, start date and duration. If possible, these numbers should be expressed net of income tax.

INVESTING RETIREMENT ASSETS If the consumer has assets that are currently earmarked for retirement, the amount and current status of these funds needs to be determined.

OTHER FINANCIAL NEEDS

Other financial needs: If the consumer has other financial needs that were not disclosed by them under the previous categories, now is the time for them to disclose them. There could be considerable overlap among several of these areas of financial considerations, but thorough questioning by the insurance

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agent can assure that the consumer has had ample opportunity to disclose all foreseeable financial needs, goals, and considerations.

HEALTH AND MEDICAL CARE ACCESS/COST

Medical care concerns: With healthcare costs soaring, the ability to afford future medical care is a concern for many. Obviously the 65 year old or older consumer can usually rely on Medicare Part A & B to form the base of their primary healthcare delivery strategy. In addition, they will need to consider some form of supplementation to the traditional Medicare as well as Medicare part D to gain access to prescription drug coverage. In the case of a couple in which one of the consumers is not yet 65, the couple needs a strategy to afford health care for the younger spouse until he/she reaches Medicare eligibility. The potential cost of the need for custodial care should not be ignored and is often addressed through the purchase of a long term care policy. Many states now have a long term care partnership-program, and the consumer should investigate the viability of insuring this risk. If a consumer needs long term care services and does not have coverage, even the best-laid financial plans can be devastated.

FINANCIAL SUPPORT FOR FAMILY MEMBERS

Financial support for family members: If the consumer is currently supporting or may in the future support family members (that weren’t counted when determining dependents earlier), the cost of providing this support needs to be estimated. Often there is a degree of uncertainty as to whether this support will be needed or not. A very common concern in this area is a child who is a single parent and struggling to make ends meet.

CROSS-SELLING REVERSE MORTGAGES One recent concern among state insurance regulators is the sale of annuities where the source of the funds is a reverse mortgage. There are currently laws in place at the federal level to prevent the same individual from selling both the reverse mortgage and an annuity to the same individual.

OTHER INFORMATION OR CONSIDERATIONS USED BY PRODUCER Any other information considered by the agent or insurer in making recommendations to consumers regarding the purchase or exchange of an annuity contract. If there is any other information that the insurance agent or insurer used in forming their reasonable basis for the recommendation, they need to document and quantify it to the highest degree possible.

ACCESS TO ACCOUNT VALUE

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REQUIRED MINIMUM DISTRIBUTIONS If the consumer holds or is purchasing a qualified annuity, care must be taken to make sure that sufficient liquidity (without surrender charges or market risks) to provide for the required minimum distributions.

WITHDRAWALS IN EXCESS OF THE FREE AMOUNT OR FULL SURRENDER In the event of a withdrawal, access to annuity values in excess of the allowed penalty-free withdrawals should be considered as well as the likelihood of a full surrender. The consumer should understand the worst case scenario if they were to exceed the free-withdrawal limit.

ANNUITIZATION The consumer should understand the annuitization options available to them. It is best to have those numbers quantified and applied to their overall retirement plan to understand how the annuity fits within their goals, resources and objectives.

DISCLOSURE AS A COMPONENT OF SUITABILITY

Disclosure is an integral part of suitability in that the consumer must have access to certain facts and information in order to make an informed decision. When consumers are considering financing the purchase of another insurance contract using some or all of the values of an existing contract, they need to understand their rights and values in the insurance or annuity contract they already own. In this course we will review the general disclosure requirements related to all annuity sales. We will also focus on replacement requirements where a “Financed Purchase” is involved. To make a generalization, most financed purchases could accurately be called replacements. There are numerous strategies used by unscrupulous agents to circumvent replacement regulations, such as not listing the existing policies as a source of funds for the purchase of the new contract and then surrendering the existing contract after the new contract is issued. Another strategy is to borrow funds from or take a partial surrender of the existing contract to initially fund the new contract (at application), and then surrender or liquidate the remainder of the existing contract and funnel the proceeds into the newly established contract The goal of various state regulations is to detect the most common strategies used to circumvent traditional replacement law, for the consumer to have sufficient information disclosed to them by the existing insurer and the new insurer.

APPROPRIATE SALES PRACTICES REQUIRE DISCLOSURE Disclosing to the consumer that the purchase of an annuity is designed to address long-term needs and goals is essential to an appropriate and suitable sale. Failure of the producer to disclose these facts is both unethical and illegal. Failure on the part of the

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consumer to understand these facts may lead to undesirable taxable events and/or the loss of principal. The following information concerning annuity contract benefits and features is typically contained in an annuity disclosure form and should be reviewed with the applicant alongside pertinent examples of each element in the contract:

• The guaranteed, non-guaranteed, and determinable elements of the contract—along with their limitations and how those limitations operate.

• The initial crediting interest rate of the annuity, including any bonus or introductory interest rates, the duration of such rates, and the fact that interest rates may change in the future and are not guaranteed.

• Guaranteed and non-guaranteed periodic options. • Value reductions (surrender charges, contingent deferred sales charges) caused by

withdrawals from, or surrender of, the annuity and the situations in which these value reductions will be assessed.

• How contract values may be assessed by the consumer, and any applicable reductions in annuity values and benefits resulting from access to contract values.

• Any available death benefits and the method of their calculation. • A summary of the federal tax status pertinent to the contract, and any applicable

tax penalties for withdrawal from the contract. • Impact, restrictions and cost of any rider.

In addition, the full disclosure and explanation to the consumer of the following elements of the proposed annuity will help them make an informed decision.

SURRENDER CHARGE TERMS Terms of Surrender Charges: For each existing annuity the surrender charge needs to be explored. If it happens to be a two tier annuity, additional understanding of the surrender charge is in order. If the annuity involves bonus amounts, the consumer’s entitlement to those amounts needs to be determined and disclosed. Specifically the details of the surrender charge that should be determined and disclosed are as follows:

Dollar Amount and surrender charge percentage: The percentage of the surrender charge, and to what values the percentage is applied, is important to understand and can be best determined by reading the contract. The actual resulting dollar amount of the surrender charge might need to be calculated if not shown.

Number of years in length: The length of the surrender charge (usually expressed in contract anniversaries or contract years) needs to be determined. Obviously, if the contract is old enough so that the surrender charge no longer applies, the consumer would need to understand this as well.

NOTE: If the existing annuity is a source of funds for the

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proposed annuity transaction and surrender charges will be assessed as part of the transaction the consumer needs to understand the dollar amounts and percents. These surrender charges represent part of the overall cost of the proposed transaction, and it can be misleading if these certain costs (in the form of a surrender charge) are offset against a bonus in the proposed annuity. Receipt of the bonus in the proposed annuity is contingent upon the consumer holding the proposed annuity for a certain period of time; whereas, the surrender charges (if any) imposed by the existing annuity are certain to occur.

COMPARISON OF LIFE EXPECTANCY TO SURRENDER CHARGE PERIOD

Comparison to life expectancy of applicant: The length of the surrender charge (in both the existing and proposed annuity) as it relates to the remaining life expectancy of the owner is also very important. If the surrender charge exceeds the consumer’s life expectancy then in essence they are making a lifetime commitment to this product, because in order to access funds (in excess of any free withdrawal allowed) at any time during their expected lifespan they will experience a surrender charge.

Waiver of surrender charge provision: Most annuities allow some waivers to their surrender charge. The various waivers and how they work were discussed earlier in this text. The more waivers and the more generously worded they are, the less restrictive the surrender charge is viewed. However, if the consumer needs access to funds during the surrender charge period and their withdrawal does not fit into one of the waivers, they will experience shrinkage of annuity values due to surrender charges.

ANNUITY TAX STATUS AND POTENTIAL TAX PENALTIES In the section on annuity taxation we covered many aspects of how the tax code impacts annuity owners. Where appropriate you should explain relevant tax aspects of the annuity to the consumer. If the consumer has tax questions specific to their tax situation, they should probably seek professional advice. MORTALITY CHARGES AND EXPENSE FEES

If any charges and fees apply at any point during the term of the annuity contract, the producer should clearly disclose either specific dollar amounts or actual percentages and explain the circumstances under which these fees apply. A variable annuity disclosure (since the product is a securities product) is required to contain more details of fees and/or charges than fixed annuity or fixed indexed annuity disclosures. An example showing this difference involves premium taxes.

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The variable annuity will disclose the premium taxes while the fixed annuity generally will not. The fixed annuity disclosure is not attempting to hide the premium tax—the tax is included in the cost structure of the fixed annuity and affects the guarantees of the product, and therefore it is not readily apparent. On the other hand, it would not be a fair comparison to state that the variable annuity has a charge for premium taxes and the fixed annuity does not. While the charge for premium taxes is not disclosed separately in the fixed annuity, it is part of the product’s overall costs. Producers should understand these differences and be able to explain them in a fair, understandable manner.

CURRENT VS. GUARANTEED INTEREST RATE The consumer must understand the difference between the current and guaranteed interest rates and the fact that the current interest rate may change. In addition, the consumer should understand the mechanism that could cause a change in current interest, whether the mechanism is a decision by the insurance company, a movement in an index, or the change in the value of an underlying equity account.

INVESTMENT ADVISORY FEES If any investment advisory fees are charged they will be disclosed in the prospectus, and the consumer should understand how they are charged.

RIDERS OR ENDORSEMENTS Contract riders or endorsements: There are many contract riders and endorsements that can be incorporated into annuities. The more common riders or endorsements are a death benefit (life insurance rider), some form of living benefit (discussed earlier), some form of living benefit based on loss of functional capacity/critical illness/dismemberment, or some form of living benefit based on terminal illness. They may also be in the form of a loan provision as part of an endorsement as a qualified retirement plan (403(b) or 401(k)). Many of the riders or endorsements are optional and are offered for a fee (usually expressed in basis points), while some are hard-coded in the product and built in to the guarantees offered by the product. The benefit and costs of each should be determined and disclosed to the consumer.

LIMITATIONS ON INTEREST RETURNS AND BENEFITS As with most contracts, each annuity contract designs benefits for a particular set of circumstances. The contract contains limitations to clearly define the intent and parameters of each benefit and/or interest credit. Limitations commonly include a required holding period, a surrender charge, and upward limit on the benefit or interest credit. The consumer should understand these contract limitations.

INSURANCE AND INVESTMENT COMPONENTS

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When the contract has separately identifiable insurance and investment components, they should be separately disclosed to the consumer.

MARKET RISK If the consumer has a risk for loss of principal in an annuity it should be disclosed. SUITABILITY OF REPLACING EXISTING POLICIES

ANNUITY COMPARISON WHEN EXCHANGING OR REPLACING AN ANNUITY If a consumer is exchanging an existing annuity for a new annuity, a comparison between the contracts should be performed. This comparison and disclosure involves revealing relevant facts about both the current annuity and the proposed annuity; the producer should contrast and compare each feature and benefit, item by item.

IF THE CONSUMER CURRENTLY HOLDS AN ANNUITY

If the consumer currently has an annuity (whether it is considered for exchange or not) the following information needs to be collected as part of the suitability determination process.

SURRENDER CHARGES EXISTING AND NEW ANNUITY If the consumer will experience a surrender charge as they exit the annuity that is being used as a source of funds for the transaction, the amount of the surrender charge should be disclosed to the consumer. The consumer should consult with their current insurer to see if changes are available within the existing annuity that meet the requirements they seek in a new annuity. The annuity that is being purchased as part of the replacement transaction will most likely have surrender charges and the consumer needs to understand how these work.

COSTS FOR ANNUITY BENEFITS

Benefits: All benefits of each annuity, including riders, options, and endorsements, should be disclosed and compared. Rarely will any two annuities be identical in benefits, so the comparison will not always be symmetrical and will demonstrate benefits in one contract that do not exist in the other and vice-versa. With many of the benefits offered by annuities, it is difficult to quantify (in dollar terms) the value of each benefit, and often the consumer has to make a value judgment based on their understanding of the benefit as it applies to them. As an insurance agent you can assist the consumer by disclosing all relevant information

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in a fair and straightforward manner.

WILL THE CONSUMER BENEFIT FROM ENHANCEMENTS IN THE NEW POLICY Part of determining suitability is to determine if the product being sold to replace an existing product has a benefit or enhancement that the consumer does not possess in their current product. Whether or not the enhancement is of value to the consumer is a decision they can only make when they understand the full cost (monetary and otherwise) of the replacement transaction. If the consumers believe that the new product will allow them benefits they don’t currently have and they feel that these benefits are worth the cost of the transaction, then they have made a value decision.

HAS THE CONSUMER HAD ANOTHER ANNUITY REPLACEMENT IN THE PREVIOUS THREE YEARS

If the consumer has had an annuity replacement within the previous three years, the potential is high that they will bail out of the product being sold to them today while a surrender charge is still effective. Since 2008 part of the regulations for the suitability of deferred variable annuities has required additional scrutiny of any annuity replacement where the consumer has had an annuity replacement within the previous 36 months.

SPECIAL ISSUES RELATED TO SALES TO SENIORS PRODUCT COMPLEXITY

As financial products become richer in benefits and attempt to address multiple needs within the same product, they can be more cost-effective. As financial products become more multifaceted, they are also becoming more complex. This is not necessarily a criticism of the products, but rather a statement that they are becoming more difficult to understand. As we age our ability to recognize, absorb and make sense of complex and abstract ideas diminishes. This is not a linear process and will proceed at different rates for different individuals. The concern with seniors, and I’ll let the reader determine their own definition of ‘senior’, is that they may have a difficult time understanding some of these more complex products. Regulators in several states have defined a senior as someone aged 65 or older, so this discussion will use that benchmark. The following section deals with recognizing diminished mental capacity and also with some of the unique ethical issues related to selling financial products to seniors.

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LEGAL CAPACITY The issue of legal capacity often arises in cases involving senior consumers. Legal capacity is the term used to define someone who is able to understand and appreciate the consequences of his/her actions. A person who lacks legal capacity cannot, for example, enter into a contract, give a power of attorney, make a will, consent to medical treatment, or transfer property. The older we become, the more likely we are to develop a mental disease or disability such as Alzheimer’s disease or dementia. If a producer sells an annuity to an individual who lacks legal capacity, it could be argued that the sale is inappropriate even if neither the producer nor the consumer was aware of the lack of mental capacity. Since basic contract law requires “competent parties” it could further be argued that the contract is not valid and binding on the incompetent individual.

DIMINISHED MENTAL CAPACITY As part of this Annuity Training Course we include information to help producers recognize when a prospective insured may lack the short-term memory or judgment to knowingly purchase an annuity. To accomplish this goal we will first distinguish between legal capacity (as described above) and diminished mental capacity. One of the most troubling issues related to the sale of insurance products to seniors is the potential for diminished mental capacity. This is a difficult and sensitive issue that is becoming more common with the aging of our population. Diminished mental capacity does not necessarily mean that one does not have legal capacity, but it does indicate that they do not function as well as they previously did. Since each individual is unique and possesses varying degrees of decision-making capabilities at various stages of their lives, it is a considerable challenge to recognize diminished mental capacity in someone that you have only just met. For the purposes of this course we will make the assumption that if someone lacks legal capacity, the agent should not need training to recognize lack of judgment and short-term memory in an individual so affected. Therefore we will focus on the recognition of diminished mental capacity which, while the lines are blurred, can be a precursor to lack of legal capacity.

PROBABILITY OF ENCOUNTERING DIMINISHED MENTAL CAPACITY A recent study published by the National Institute on Aging reveals that impaired cognitive ability (diminished mental capacity) affects approximately 20 percent of people aged 85 years or older.

RECOGNIZING DIMINISHED MENTAL CAPACITY For an individual not formally trained in a mental health discipline, assessing diminished capacity is possible in some very clear cases, but in general, diagnosing mental and

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physical capacity is well beyond the professional training and expertise of the average insurance producer. Several factors make assessing diminished mental capability difficult. Many individuals have occasional memory problems due to the natural aging process and take longer to make decisions. Loss of memory and/or the onset of diminished mental capacity is usually a gradual process that can accelerate over time. It is entirely possible that a senior could make an insurance-related decision today when they appear to be cognitive and two or three years later (when a consumer complaint arises) be considered cognitively impaired. First, it is always important that the marketing and provision of any financial services to senior citizens be done in an appropriate manner, and that the financial services and products be appropriate to these consumers with regards to age, risk tolerance, and understanding of the product being offered. Diminished mental capacity may sometimes be difficult to identify, or may have pronounced symptoms. Below is a listing of several indicators of diminished mental capacity that can alert the producer. Not all of these indicators will be observable in the context of a typical meeting between an insurance producer and consumer. Additionally, some of these indicators require a prior knowledge of the consumer in order to determine if there has been deterioration in a particular aspect of their behavior.

INDICATORS OF DIMINISHED MENTAL CAPACITY

• Memory loss: The senior is repeating questions, forgetting details, forgetting appointments, misplacing items or losing track of time.

• Disorientation: The senior is confused over time, place, or simple concepts.

• Difficulty performing simple tasks: The senior lacks the ability to remember the order of performance of the steps necessary to complete a simple task, such as tying their shoes.

• Difficulty speaking: The senior uses words that do not fit the context of their use.

• The senior appears unable to appreciate the consequences of decisions.

• The senior makes decisions that are inconsistent with his or her current long-term goals or commitments.

• The senior seems overly optimistic.

• Difficulty following simple directions: The senior has difficulty with directions, particularly when the directions include multiple steps that must be performed in a certain order.

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• Deterioration of handwriting and signature: The senior appears unable to accurately write the letters of the alphabet. They may write a C or an R backwards.

• Drastic mood swings: The senior may exhibit a swift change in mood within a short period of time with no obvious reason for the mood change.

• The senior does not remember or understand recently completed financial transactions.

• Disorientation: The senior appears to be disoriented with surroundings or social setting.

• Lack of attention to personal hygiene: The senior appears uncharacteristically unkempt.

• Confusion as to date and time: The senior may be confused as to the season of the year, the current month, the day of the week or the time of the day.

• ADDITIONAL INDICATORS

Below is an additional list of indicators that can best be judged by someone (such as a close relative or long time friend) with day to day exposure to the senior or someone who has known the senior for a long time, even if their exposure is infrequent.

• Changes in personality.

• Increased passivity.

• Poor judgment.

• Are they taking their medication when they should?

• Do they open their mail and pay their bills on time?

EXPLANATION OF INDICATORS

The Alzheimer’s Association has a listing of explanations for some of the indications of Alzheimer’s Disease. While this information relates to the recognition of Alzheimer’s, it also puts these indicators into perspective. These can be of value to a producer in recognizing signs of short term memory loss and/or lack of judgment.

Memory loss that affects job skills. It's normal to occasionally forget an item at the grocery store, deadline or colleague's name, but frequent forgetfulness or unexplainable confusion at home or in the workplace may signal something wrong. Difficulty performing familiar tasks. Busy people get distracted from time to time. For example, you might leave something on the stove too long or not remember to serve part of a meal. People with Alzheimer's disease might prepare a meal and not only forget to serve it but also forget they made it.

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Problems with language. Everyone has trouble finding the right word sometimes, but a person with Alzheimer's disease may forget simple words or substitute inappropriate words, making his or her sentences difficult to understand. Disorientation of time and place. It's normal to momentarily forget the day of the week or what you need from the store. But people with Alzheimer's disease can become lost on their own street, not knowing where they are, how they got there or how to get back home. Poor or decreased judgment. Choosing not to bring a sweater or coat along on a chilly night is a common mistake. A person with Alzheimer's, however, may dress inappropriately in more noticeable ways, wearing a bathrobe to the store or several blouses on a hot day. Problems with abstract thinking. Balancing a checkbook can be challenging for many people, but for someone with Alzheimer's disease, recognizing numbers or performing basic calculation may be impossible. Misplacing things. Everyone temporarily misplaces a wallet or keys from time to time. A person with Alzheimer's disease may put these and other items in inappropriate places -- such as an iron in the freezer or a wristwatch in the sugar bowl -- and then not recall how they got there. Changes in mood or behavior. Everyone experiences a broad range of emotions -- it's part of being human. People with Alzheimer's disease tend to exhibit more rapid mood swings for no apparent reason. Changes in personality. People's personalities may change somewhat as they age. But a person with Alzheimer's can change dramatically, either suddenly or over a period of time. Someone who is generally easygoing may become angry, suspicious or fearful. Loss of initiative. It's normal to tire of housework, business activities or social obligations, but most people retain or eventually regain their interest. The person with Alzheimer's disease may remain uninterested and uninvolved in many or all of his usual pursuits.

ETHICAL AND COMPLIANCE ISSUE UNIQUE TO THE SENIOR MARKET

STRATEGIES FOR MAKING BETTER DECISIONS In order to increase the likelihood of the senior making an informed decision there are several strategies that can be used. They are as follows:

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• Try to arrange your meetings with seniors as early in the morning as convenient. When they are well rested they tend to make better decisions and have better cognitive function.

• Ask the senior to include a trusted family member to attend the meeting and

assist with the decision making.

• Ask the senior to repeat their understanding of your explanations of the different elements of the financial product being presented.

• Break the explanations and decisions down into smaller components and

make sure the senior has a firm understanding at each juncture before proceeding.

INCLUDING A TRUSTED FAMILY MEMBER In discussing the practice of asking a trusted family member to attend the meeting, it should be noted that privacy regulations may have an impact in this area. Another complication regarding involving a trusted family member is that when senior financial abuse is discovered it is often a trusted family member who is the perpetrator.

SENIOR-RELATED PROFESSIONAL DESIGNATIONS State insurance regulators are concerned about certain producers using “industry designations” that imply a heightened, unique or special qualification and/or specialized education that would make them better qualified to address the insurance needs of elders. Many of these “senior affinity” designations lack the underpinning of traditional designations such as:

• Rigorous education and testing requirements for designation candidates.

• An enforceable code or canon of ethics.

• Continuing education requirements to maintain the designation. As a result of the proliferation of these designations, many states have adopted rules prohibiting the use of misleading senior designations and have provided a mechanism for creditable designation to be accredited.

THE NEED FOR COMPLETE RECORDKEEPING As a producer in the financial services industry it is imperative that you become a good record keeper. Not only do regulations require adequate records be retained, but it also helps the producer to better serve the consumer.

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As part of the NAIC Annuity Suitability Model Act, a producer must have reasonable grounds for believing that a recommendation to a consumer is appropriate. In order to substantiate the belief that a recommendation was appropriate, the producer needs a record of the information collected from the consumer that was used to formulate the recommendation. Most insurers have developed forms to meet the requirements of suitability, and transactions will be reviewed at the carrier level to ensure suitability. Producers are best-positioned to gather and document accurate consumer information.

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Chapter 3 - Review Questions (Answers are in the back of the text)

1. The NAIC Suitability in Annuity Transactions Model Regulation shall apply to any recommendation to ________________ an annuity made to a consumer by an insurance producer, or an insurer where no producer is involved, that results in the purchase, exchange or replacement recommended.

(a) Purchase (b) Exchange (c) Replace (d) Purchase, exchange or replace

2. The NAIC Suitability in Annuity Transactions Model Regulation applies to:

(a) Group annuities only (b) Individual annuities only (c) Group and/or individual annuities (d) Only annuities used to fund qualified employer retirement plans

3. The NAIC Suitability in Annuity Transactions Model Regulation requires that if a customer refuses to provide suitability information, the insurance producer, or an insurer where no insurance producer is involved, _____________.

(a) Must provide the customer with an explanation of the purpose of requesting the suitability information and the potential repercussions of not providing the suitability information. (b) Proceed with the sale since the consumer was given the opportunity to provide the information. (c) Must not transact an annuity transaction with the customer. (d) Must estimate the information not provided to the best of their abilities.

4. The NAIC Suitability in Annuity Transactions Model Regulation requires that an insurance producer who engages in the sale of annuity products shall complete a one-time ________ training course approved by the department of insurance and provided by the department of insurance-approved education provider.

(a) Two hour (b) Four hour (c) Six hour (d) Eight hour

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Answers to Chapter - Review Questions

Chapter 1

1. The correct answer is: C (page 7) 2. The correct answer is: B (page 5) 3. The correct answer is: B (page 6) 4. The correct answer is: A (page 26) 5. The correct answer is: A (page 9) 6. The correct answer is: C (page 31)

Chapter 2

1. The correct answer is: B (page 57) 2. The correct answer is: D (page 59) 3. The correct answer is: D (page 59) 4. The correct answer is: C (page 59)

Chapter 3

1. The correct answer is: D (page 70) 2. The correct answer is: C (page 71) 3. The correct answer is: A (page 74) 4. The correct answer is: B (page 77)