You are on page 1of 15

Chapter 19

Retirement Products: Annuities and Individual Retirement


Accounts

Overview

Thus far we have examined life insurance in great detail. Life insurance companies also market a product
that addresses another important personal risk. That personal risk is the risk of outliving the income and
assets that you have accumulated. The product that addresses this personal risk is called a life annuity.
Life annuities provide periodic income to an individual for as long as he or she is living. These products
help many retirees to achieve economic security. In addition to annuities, individuals have another
retirement savings vehicle available to them. An individual may establish a tax-advantaged savings plan
called an individual retirement account (IRA). In this chapter we will examine the characteristics of
individual annuities and IRAs (traditional and Roth). Group retirement plans and retirement plans for the
self-employed are discussed in Chapter 22.

Learning Objectives

After studying this chapter, you should be able to:


Show how an annuity differs from life insurance.
Describe the basic characteristics of a fixed annuity and a variable annuity.
Explain the major characteristics of an equity-indexed annuity.
Describe the basic characteristics of a traditional tax-deductible individual retirement account (IRA).
Explain the basic characteristics of a Roth IRA.
Explain the income tax treatment of a traditional IRA and a Roth IRA.
Define the following:
Inflation-indexed annuity option
Accumulation period
Installment refund annuity
Accumulation unit
IRA rollover account
Annuitant
Joint-and-survivor annuity option
Annuity
Life annuity (no refund)
Annuity settlement options
Life annuity with guaranteed payments
Annuity unit
Liquidation period
Cash refund annuity
Nondeductible IRA
Deferred annuity
Roth IRA
Equity-indexed annuity
Single-premium deferred annuity
Exclusion ratio
Spousal IRA
Fixed annuity
Traditional IRA
Flexible-premium annuity
Variable annuity
Immediate annuity
Individual retirement account (IRA)
2011 Pearson Education, Inc.

Outline
I. Individual Annuities

II. Types of Annuities


A. Fixed Annuity
1. Payment of Benefits
2. Annuity Settlement Options
B. Variable Annuity
1. Basic Characteristics
2. Guaranteed Death Benefit
3. Fees and Expenses
C. Equity-Indexed Annuity
1. Participation Rate
2. Maximum Cap Rate or Cap
3. Indexing Method
4. Guaranteed Minimum Value
III. Taxation of Individual Annuities
IV. Individual Retirement Accounts
A. Traditional IRA
1. Eligibility Requirements
2. Annual Contribution Limits
3. Income Tax Deduction of Traditional IRA Contributions
4. Spousal IRA
5. Tax Penalty for Early Withdrawal
6. Taxation of Distributions
7. Establishing a Traditional IRA
8. IRA Investments
9. IRA Rollover Account
B. Roth IRA
1. Income Limits
2. Conversion to a Roth IRA
V. Adequacy of IRA Funds

Chapter 19

Retirement Products: Annuities and Individual Retirement Accounts

Short Answer Questions

1. Explain the annuity principle. Why is it said that annuities are the opposite of life insurance?

2. Explain the elements that comprise life annuity payments.

3. Differentiate between the accumulation period and the liquidation period of a fixed annuity.

443

444

Rejda Principles of Risk Management and Insurance, Eleventh Edition

4. Explain the life annuity (no refund), life annuity with guaranteed payments, and installment refund
settlement options.

5. Discuss the mechanics of a variable annuity.

6. Explain why an equity-indexed annuity is said to have characteristics of both a fixed annuity and a
variable annuity.

Chapter 19

Retirement Products: Annuities and Individual Retirement Accounts

445

7. Explain the tax treatment of the periodic annuity payments that a retiree receives from an individual
annuity.

8. Are traditional IRA contributions fully income-tax deductible, partially deductible, or not deductible?
Explain your answer.

9. Under what circumstances can withdrawals be made from a traditional IRA before age 59.5 without
incurring the early withdrawal penalty tax?

446

Rejda Principles of Risk Management and Insurance, Eleventh Edition

10. How does a Roth IRA differ from a traditional IRA with respect to
(a) tax deductibility of contributions?

(b) tax treatment of qualified distribution?

Multiple Choice Questions

Circle the letter that corresponds to the BEST answer.


1. Which of the following statements is (are) true with respect to annuities?
I. Annuities pool the risk of premature death.
II. Life annuities provide an income that the annuitant cannot outlive.
(a)
(b)
(c)
(d)

I only
II only
both I and II
neither I nor II

2. Income paid to an annuitant under a life annuity is comprised of all of the following EXCEPT:
(a) interest earnings
(b) insurer expenses
(c) premiums paid
(d) unliquidated funds from those who die early

Chapter 19

Retirement Products: Annuities and Individual Retirement Accounts

447

3. Agnes, age 62, purchased an immediate annuity. The annuity will provide monthly payments to
Agnes for as long as she lives. If Agnes dies before receiving payments for 10 years, the balance
of these payments will go to a beneficiary. Agnes purchased a(n)
(a) life annuity (no refund)
(b) life annuity with guaranteed payments
(c) installment refund annuity
(d) joint-and-survivor annuity
4. Which of the following statements is (are) true with respect to a joint and survivor annuity?
I. Payments begin upon the death of the first annuitant.
II. Payments end upon the death of the last annuitant.
(a)
(b)
(c)
(d)

I only
II only
both I and II
neither I nor II

5. Thomas wants to participate in the growth of the stock market through a deferred annuity; however
he wants downside protection against the loss of principal and prior investment earnings if the
annuity is held to term. Thomas should purchase a(n)
(a) equity-indexed annuity
(b) variable annuity
(c) fixed annuity
(d) life income (no refund) annuity
6. Rochelle is preparing to do her taxes. To determine what percentage of her individual annuity
income was taxable and not taxable, Rochelle divided her investment in the annuity by the total
of the expected payments that she will receive through the annuity. This quotient is called the
(a) percentage participation
(b) break-even point
(c) coinsurance percentage
(d) exclusion ratio
7. All of the following statements about traditional IRAs are true EXCEPT:
(a) No traditional IRA contributions are allowed for the tax year in which the participant
attains age 70.5 (seventy and one-half) or for any later year.
(b) If pre-tax contributions fund the IRA, the entire distribution is taxable.
(c) Everyone is eligible to establish a traditional IRA and make fully tax-deductible contributions.
(d) IRA funds can be invested in stocks, bonds, mutual funds, and certificates of deposit.
8. Which of the following statements is true regarding a traditional IRA?
I. Contributions may be fully deductible, partially deductible, or not deductible.
II. In certain circumstances, withdrawals are permitted before age 59.5 without triggering the early
withdrawal penalty tax.
(a)
(b)
(c)
(d)

I only
II only
both I and II
neither I nor II

448

Rejda Principles of Risk Management and Insurance, Eleventh Edition

9. Kathy would like to save for retirement. She selected a plan through which she can make a limited
contribution each year. Her contribution is not tax deductible, however the investment income
accumulates income tax free, and qualified distributions from the plan are not taxed. Kathy is
funding a(n)
(a) variable annuity
(b) Roth IRA
(c) traditional IRA
(d) equity-indexed annuity
10. Some employers make a lump-sum distribution of pension assets to workers who are terminating
employment. To avoid receiving the account assets directly and having to pay taxes on the distribution,
the funds may be deposited tax-free into a special account. Such an account is called a(n)
(a) spousal IRA account
(b) Roth IRA account
(c) Section 401(k) account
(d) IRA rollover account

True/False

Circle the T if the statement is true, the F if the statement is false. Explain to yourself why a statement
is false.
T

1. The fundamental purpose of a life annuity is to provide an income that cannot be outlived.

2. It is impossible for an insurer to make a profit by selling a refund annuity.

3. Annuities can be funded through a single premium or through multiple premiums.

4. During the funding period, a variable annuity purchaser is credited with annuity units.

5. A key advantage of variable annuities is that insurers marketing these products do not charge
any fees.

6. Equity-indexed annuities provide downside protection against the loss of investment income
if the annuity is held to term.

7. Income from individual annuities is received tax-free by the annuitant at retirement.

8. Roth IRA contributions are tax deductible regardless of a persons income and whether or not
he or she is covered by an employer-sponsored retirement account.

9. Most spouses who do not work outside of the home can make a fully deductible contribution
to a traditional IRA even through their spouse is covered under a retirement plan at work.

F 10. Qualified distributions from traditional IRAs are received income tax-free after age 59.5.

F 11. Qualified distributions from Roth IRAs are received income tax-free after age 59.5.

F 12. In come cases, qualified distributions from Roth IRAs can be made before age 59.5.

Chapter 19

Retirement Products: Annuities and Individual Retirement Accounts

449

Case Applications

Case 1
Andrea is considering the purchase of an annuity. She was surprised to learn about all of the annuity
options that are available. She is also wondering how annuity income will be taxed upon her retirement.
a.

Differentiate between:
(1) Immediate and deferred annuities:

(2) Single-premium annuities and flexible-premium annuities:

(3) The life annuity no refund, life annuity with guaranteed payments, and installment refund annuity
settlement options:

450

b.

Rejda Principles of Risk Management and Insurance, Eleventh Edition

Assume that Andrea invests $120,000 in a life annuity. At the time she begins to receive monthly
distributions of $1000, her life expectancy is 20 years. What is Andreas exclusion ratio for this
annuity?

Case 2
Which IRA (traditional or Roth) would you recommend in the two scenarios described below?
a.

Charlene is single and will earn $40,000 this year. She is not eligible to participate in her employers
pension plan until next year.

b.

Vern is concerned that all of his retirement distributions will be taxable once he starts to receive the
money. Vern earns $90,000 per year and is covered under his employers qualified retirement plan.

Chapter 19

Retirement Products: Annuities and Individual Retirement Accounts

451

Solutions to Chapter 19

Short Answer Questions


1. Annuities pool the risk of excessive longevity in order to provide an income that cannot be outlived.
By pooling the risk of excessive longevity, insurers offering life annuities are able to continue
payments to those who live far beyond life expectancy. Some individuals in the pool will die early,
freeing-up the unliquidated portion of their premiums to assist the insurer in continuing to make
payments to those who live far beyond life expectancy.
Life insurance and life annuities can be viewed as opposites as one provides protection against the
adverse financial consequences of premature death while the other provides protection against the
adverse financial consequences of excessive longevity. Life insurance creates an immediate pool of
funds while life annuities are a means through which a pool of funds is systematically liquidated.
2. Life annuity payments are comprised of three elements. First, there is a return of premiums that were
paid for the annuity. Second, there is interest income that was earned on the funds invested by the
insurer. Finally, some life annuitants die before receiving back from the insurer what they paid for
the annuity. This third component is the unliquidated principal of annuitants who die early.
3. The accumulation period of an annuity is the time when premiums are being paid and/or interest is
being earned on the premiums paid to the insurer. This period is the time before the insurer begins to
make payments to the annuitant. During the liquidation (payout) period, the insurer is making
periodic payments back to the annuitant.
4. There are a number of settlement options for life annuities:
The life annuity (no refund) provides the highest periodic income payment to the annuitant. This
annuity provides no guarantees. Payments are made until the annuitant dies, and upon the death of
the annuitant, payments end.
The life annuity with guaranteed payments is a life annuity that promises that at least a specified
number of payments will be made. For example, under a life income with 10 years for certain
annuity, the insurer promises that payments will be made for at least 10 years. If the annuitant dies
before receiving the minimum number of guaranteed payments, a beneficiary will receive the
balance of the guaranteed payments. After the guaranteed period, the annuity is just like any other
life annuitythe insurer continues to make payments until the annuitant dies.
The installment refund option is a life annuity that promises the insurer will pay out at least the
total of the premiums paid for the annuity. Under this type of annuity, if the annuitant dies before
receiving from the insurer at least what was paid in premiums, annuity payments continue to a
beneficiary until at least what was paid for the annuity has been paid out by the insurer. After the
insurer has paid out an amount equal to the premiums paid for the annuity, the annuity is just like
any other life annuity.
5. Variable annuities can be funded through a lump sum contribution or through periodic installment
premiums. During the funding period, the purchaser is credited with accumulation units. The value of
accumulation units fluctuates with the performance of the securities in the portfolio supporting the
annuity. During the funding period, the purchaser continues to buy accumulation units. At retirement,
the accumulation units are converted to annuity units. The purchaser will have a fixed number of
annuity units throughout retirement, however the value of the units, and hence the periodic income
distribution, will fluctuate with the value of the investment portfolio supporting the annuity.

452

Rejda Principles of Risk Management and Insurance, Eleventh Edition

6. An equity-indexed annuity provides the possibility of earning a higher, variable rate of return with
downside risk protection as the return can never drop below a specified fixed interest rate. The
annuity value is linked to the performance of a stock market index. If the stock market rises, the
annuity is credited with a portion of the investment gain (e.g. 80 percent of the return, up to a
specified cap). If the stock market declines, the annuity earns at least a minimum return, which
typically is 3 percent on 90 percent of the principal invested. So while the annuity can profit from
superior investment performance like a variable annuity, it also provides a minimum guaranteed
interest rate, like a fixed annuity, when investment performance is unfavorable.
7. Premiums for individual annuities are not income-tax deductible and are paid with after-tax dollars.
The investment income, however, is tax-deferred and accumulates free of taxes until the funds are
distributed. The portion of an annuity distribution that is investment income is taxed as ordinary
income. The portion of the payment that is a return of premiums is received tax-free. To determine
the portion received tax-free and the taxable portion, it is necessary to calculate an exclusion ratio.
The formula for the exclusion ratio is total annuity premiums paid divided by the expected payments
to be received. This value is determined by multiplying the periodic income by life expectancy. If the
exclusion ratio is multiplied by the periodic income payment, the resulting value is the nontaxable
amount. The balance of the payment is taxable. Once the total investment in the annuity has been
recouped, the entire annuity distribution is taxable.
8. Traditional IRA contributions may be fully tax deductible, partially tax deductible, or not tax
deductible:
To be fully tax-deductible, the worker must not be an active participant in an employer-sponsored
retirement plan. Such a worker can make a fully deductible IRA contribution. Even if the worker
is covered by an employer-sponsored plan, a deduction is permitted if the workers modified
adjusted gross income is below a specified amount.
If the modified adjusted gross income is within a threshold band, a partially tax deductible IRA
traditional IRA contribution can be made.
No deduction is permitted for taxpayers who have a modified adjusted gross income in excess of
the phase-out deduction limit. Such taxpayers, however, should consider making a contribution to
a Roth IRA if they are eligible.
9. The early withdrawal penalty does not apply in the following cases: distributions used to pay for
unreimbursed medical expenses exceeding 7.5 percent of adjusted gross income (AGI), distributions
not exceeding the cost of medical insurance if you lost your job and received unemployment
compensation for 12 consecutive weeks, disability of the IRA owner, distributions to the beneficiary
of a deceased IRA owner, distributions that are part of substantially equal payments paid over the life
expectancy of the individual, distributions that are not more than qualified higher education expenses,
qualified acquisition costs for a first-time home buyer (maximum of $10,000), distributions due to an
IRS levy on the qualified plan, and qualified reservist distributions.
10. (a) As discussed in question #8, traditional IRA contributions may be fully deductible, partially
deductible, or not deductible. The contributions made to a Roth IRA are never tax deductible.
(b) Distributions from traditional IRAs are taxed as ordinary income except for any nondeductible
IRA contributions, which are received income-tax free. Under a Roth IRA, after-tax contributions
are made and investment income accumulates tax-free. If certain requirements are met, the entire
distribution is received free of taxes.

Chapter 19

Retirement Products: Annuities and Individual Retirement Accounts

453

Multiple Choice Questions


1. (b) Only the second statement is true. Annuities do not pool the risk of premature death. Annuities
pool the risk of excessive longevity. Life annuities continue to make payments for as long as the
annuitant is alive.
2. (b) Insurer expenses are not part of life annuity payments. Annuity payments are comprised of a
return of premiums paid, interest, and unliquidated funds from annuitants who die early.
3. (b) Agnes purchased a life annuity with guaranteed payments. In this case, the insurer has promised
to make at least 120 payments (10 years 12 months).
4. (b) Only the second statement is true. Payments do not begin upon the death of the first annuitant.
Payments are made jointly to the annuitants and continue until the last annuitant has died.
5. (a) An equity-indexed annuity will accomplish the goals that Thomas has set forth. He has the
downside protection of a guaranteed minimum rate of return, while he still has the potential of
earning higher equity returns.
6. (d) Rochelle calculated the exclusion ratio. The ratio tells her what percentage of the individual
annuity distribution she can exclude from taxation as it represents a return of premiums paid for
the annuity. The balance (the amount not excluded) is fully taxable.
7. (c) There are eligibility rules for establishing a traditional IRA. Contributions may be fully, partially,
or not tax deductible, depending on an individuals income and whether he or she is covered
under an employers retirement plan.
8. (c) Both statements are true. Depending on the eligibility status of the contributor and his or her
income level, the contribution may be fully tax deductible, partially tax deductible, or not tax
deductible. There are a number of situations in which distributions may be taken from traditional
IRAs before age 59.5 without triggering the 10 percent penalty tax.
9. (b) Kathy is funding a Roth IRA. After-tax contributions are used, but qualified distributions from
Roth IRAs after age 59.5 are received tax-free.
10. (d) Distributions made to an IRA rollover account do not result in current taxation.

True/False
1. T
2. F While it is true that the insurer will pay out an amount that is at least equal to the premiums paid
for the annuity, the issue is timing. The repayment of all of the money paid for the annuity may take
many years. At the same time, however, the insurer will be investing the funds and earning
investment income on the premiums.
3. T
4. F During the funding period, the variable annuity purchaser is credited with accumulation units, not
annuity units.

454

Rejda Principles of Risk Management and Insurance, Eleventh Edition

5. F Insurers marketing variable annuities charge a variety of fees and expenses, including management
fees, administrative fees, surrender charges, and expense charges.
6. T
7. F A portion of the distribution, the amount which is attributable to a return of premiums paid, is
received tax-free. The balance, which is investment income, is fully taxable. After the basis in the
annuity has been recovered, the entire distribution becomes taxable income.
8. F Roth IRA contributions are never tax deductible. Roth IRA contributions are made with after-tax
dollars, but the distributions at retirement are received tax-free.
9. T
10. F It pre-tax dollars are used to fund traditional IRAs, distributions from traditional IRAs at
retirement are fully taxable. If any after-tax contributions were used to fund the traditional IRA,
the portion of the distribution attributable to the after-tax contribution is received tax-free.
11. T
12. T

Case Applications
Case 1
a.

(1) Immediate annuities begin to make payments to the annuitant in the period after the annuity is
purchased. For example, a retiree may give a life insurance company $50,000 in exchange for an
immediate annuity and begin to receive payments from the life insurer in the following month. A
deferred annuity begins more than one period after the premium was paid. For example, an annuity
purchaser age 30 may pay premiums over 20 years, then stop paying premiums, and begin to
receive payments from the insurer at age 65.
(2) Single premium annuities are funded through one, lump-sum, premium. Flexible premium
annuities are funded through premiums paid over a number of years. Often level installment
premiums are used to fund an annuity.
(3) A life annuity, no refund annuity has no special guarantees for the annuitant. Payments are made
until the annuitant dies. If the annuitant dies after receiving only one or two payments, there
are no refunds or guaranteed payments. A life annuity with guaranteed payments promises to
make at least a specified number of payments. For example, life income with 10 years for certain
promises to make at least 120 monthly payments. If the annuitant dies before receiving all
120 payments, the balance of the promised payments is paid to a beneficiary. An installment
refund option promises that the amount paid by the insurer will be at least the sum of the
premiums paid for the annuity. So if the annuitant has received payments totaling $100,000 when
he or she dies, and $120,000 was paid for the annuity, payments will continue to a beneficiary
until the additional $20,000 has been paid-out by the insurer.

b.

Andreas exclusion ratio is 50 percent as shown below:

$120,000 in premiums
= 50% exclusion ratio
$240,000 in expected payments

Chapter 19

Retirement Products: Annuities and Individual Retirement Accounts

455

The $240,000 in the denominator was obtained by multiplying $1000 per month by 12 months and
20 years ($1000 12 20 = $240,000).
So Andrea can exclude 50 percent of the annual annuity income from taxation because it represents a
return of premiums. Once the return of premiums equals $120,000, then the entire annual annuity
distribution becomes fully taxable.
Case 2

a.

A traditional IRA makes sense for Charlene. Given that Charlene is not covered under her employers
retirement plan and her income does not exceed the limit, she can make a fully-deductible traditional
IRA contribution. The contribution will reduce her current taxable income and accumulate on a taxdeferred basis.

b.

Vern does not qualify for a tax-advantaged traditional IRA contributionhis income is too high and
he is covered under a qualified retirement plan through his employer. Vern can, however, make a
contribution to a Roth IRA using after-tax dollars. Although the contribution is made with after-tax
dollars, the IRA accumulates on a tax-deferred basis. If certain rules are satisfied, Verns entire
distribution from the Roth IRA will be received tax-free when he retires.