Annuities

1.

Reverse application of the law of large

numbers as it is used in life insurance.

2.

Law of averages permits a lifetime

guaranteed income to each annuitant.

3.

Persons who live longer than average offset

those who live a shorter-than-average
period.

4.

Every payment to annuitant is part interest,

part principal, and part survivorship benefit.
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Annuities
Classification of annuities
1.

Individual versus Group

2.

Fixed versus Variable

3.

Immediate versus Deferred

4.

Single Premium versus Installment

5.

Single Life versus Two or More Lives

6.

Pure Life Annuity versus Annuity Certain

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Annuity Certain Contracts

1.

Pure life annuity

2.

Life annuity with period certain

3.

Life annuity with installment refund

4.

Life annuity with cash refund

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Tax Treatment of Annuities

Investment
Nontaxable
Payment X
in Contract
=
Return of
Expected Return
Capital

$6,000

$6,000

$60,000
($500 X 12) X 15

$60,000

$60,000
$90,000

$4,000

$90,000
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Specialized Annuities
Single-Premium Deferred Annuity
1. Increased popularity since TRA-86
eliminated many tax shelters.
2. Currently taxed same as other annuities:
earnings accumulate on tax-deferred basis.
3. Some insurers sell SPDAs with deposit
premium as low as $2,500, but more
common minimum is $10,000.
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Specialized Annuities
Market-Value Adjusted Annuities
1.

Cross between variable and fixed dollar

annuities

2.

Interest rate is fixed for a specified period,

but cash surrender value fluctuates with
value of underlying securities if policy is
surrendered before end of period

3.

At set intervals (e.g., 5 or 10 years)

withdrawals permitted without market
value adjustment
18-6

Specialized Annuities
Two-Tier Annuity
1. A dual value, dual interest annuity
accumulation value, equal to premiums
paid plus interest
surrender value, which is subject to a
permanent increasing surrender charge,
designed to discourage lump-sum
withdrawals
2. Accumulation value is available only under
an annuity pay-out
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Specialized Annuities
Reversionary or Survivorship Annuity
1.

Life insurance on one person (nominator).

2.

Policy proceeds paid as a lifetime annuity

to the beneficiary (annuitant).

3.

If beneficiary dies before the nominator,

the policy expires without value.

4.

Usually written with a young person as the

nominator and an older person (e.g.,
parent) as the annuitant.
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Equity-Indexed Annuities
First appeared in 1996 and quickly captured a
significant portion of the annuities market.
A fixed annuity that earns interest or provides
benefits linked to performance of an equity
index, such as the S&P 500.
Generally, the crediting rate is a function of
the relative change in the index,
the participation rate (i.e., percentage of index
growth passed on to policyholders),
any caps imposed on the crediting rate.
Also usually have minimum interest guarantees
and comply with the minimum nonforfeiture law.
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Variable Annuity
1. Designed as means of coping with inflation.
2. Premiums invested in common stocks or
similar investments.
3. Based on assumption that the value of a
diversified portfolio of common stocks will
change in the same direction as price level.
4. Variable annuity may be variable during
accumulation period and fixed during
payout period of variable during both
accumulation and payout period.
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History of Variable Annuity

1.

Originated in 1952 by CREF, which was

created by the TIAA for college faculty.

2.

First variable annuities for the public were

issued in 1954 by PALIC of Little Rock,
Arkansas, (intrastate only) followed by
VALIC (interstate).

3.

Litigation over regulation by the SEC or

state insurance departments was settled
by U.S. Supreme Court: currently
regulated by both SEC and the states.
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CREF Performance
Year
1952
1955
1960
1965
1970
1975
1980
1985
1990
1995
1998

Unit
Value
$1.02
1.95
3.39
5.40
6.17
6.48
11.71
24.42
44.41
80.81
151.74
18-12

Annuities as Investments for Retirement

1.

Return earned over life of an annuity

depends on several features.

2.

Most important determinants of the rate of

return are:
interest rate
surrender charge
administrative expenses

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Annuities - Interest
1. Current rate of interest is guaranteed for
a specified number of years, after which it
may be changed, subject to a specified
minimum.
2. Guarantee period may range from 1 year to
up to 10.
3. Usually, the longer the guarantee period,
the lower the guaranteed rate.
18-14

Annuities - Surrender Charges

1.

Although some insurers still use a frontend sales fee (4% or 5% of premium), most
insurers use a surrender fee for early
withdrawals.

2.

Surrender fee usually begins at from 8% to

10% and declines to zero after from 7 to 15
years.

18-15

Annuities - Administrative Expenses

In addition to the surrender charges, most
insurers charge an administrative fee.
annual maintenance fee usually from $25 to
$50.
for variable annuities, asset management
feels ranging from 0.25% to 2% of
accumulated assets are charged.

18-16

Qualified Retirement Plans

Qualified plans are those that conform to the
requirements of federal tax laws and for which
the law provides favorable tax treatment.
1. Employee contributions are tax
deductible when they are made.
2. Employee is not taxed on employers
contribution or investment earnings until
benefits are distributed.

18-17

ERISA
Employee Retirement Income Security Act of
1974 (ERISA) establishes federal standards for
qualified retirement plans:
1. Prescribes which employees must be
included.
2. Establishes minimum vesting standards.
3. Sets minimum funding standards.
4. Requires extensive reporting and
disclosure information about pensions
and other employee welfare programs.
18-18

Qualification Requirements
1.
2.
3.
4.

Designed for exclusive benefit of employees.

In writing and communicated to employees.
Must meet one of several vesting schedules.
Cannot discriminate in favor of officers, stockholders or highly compensated employees.
5. Must provide for definite contributions by
employer or definite benefits at retirement.
6. Life insurance included only on an incidental
basis.
7. Top-heavy plans are subject to special vesting
and contribution requirements.
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Vesting Requirements
1.

No vesting for 5 years, 100% vested after 5

years.

2.

20% vested after 3 years with 20% per year

thereafter so employee is 100% vested at
the end of 7 years.

3.

For top-heavy plans:

100% in three years, or

20% per year after first year

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Types of Qualified Plans

1.
2.
3.
4.
5.
6.
7.
8.
9.

Defined Benefit Pension Plans

Defined Contribution Pension Plans
Qualified Profit-sharing Plans
Employee Stock Ownership Plans
Section 401(k) Plans
Simplified Employee Pensions
Keogh Plans
Section 403(b) Plans
SIMPLE IRAs and SIMPLE 401(k) plans
18-21

Factors Influencing Benefit Levels

Benefit received by employees at retirement is
based on a formula applicable to all
employees.
1. All plans fall into one of two benefit
formula categories
defined contribution
defined benefit.
2. Plans may be contributory (with employee
contributions) or noncontributory (where
employer bears the entire cost).
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Employee Contributions
1.

When employees contribute to a profitsharing plan, it is usually called a thrift

or savings plan.

2.

Employee contributions are not usually

deductible, but investment income on
such contributions is exempt from taxes
until distributed.

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Amount of Benefits or Contributions

Defined Contribution Plans
1.

Work exactly as the name implies:

employers contribution is set by the
employment agreement

2.

Contribution is usually a percentage of

compensation, such as 5% or 10% of
employee wages

18-24

Amount of Benefits or Contribution

Defined Benefit Plans
1. In defined benefit plan, amount of benefits
employee will receive is specified in the
benefit formula
2. In most benefit formulas, retirement benefit
is a function of employees salary, the
benefit accrual rate, and employees years
of service
3. Most plans are final average salary plans
but some are career average salary plans.
18-25

Amount of Benefits or Contributions

FINAL AVERAGE SALARY PLAN
Benefit depends on salary earned in final years
of employment and number of years worked
example: 1% of average monthly salary
during final three years of employment for
each year employed
an employee with 35 years employment
would receive 35% of average monthly
employment in the final three years
18-26

Amount of Benefits or Contributions

CAREER AVERAGE SALARY PLAN
Benefit depends on salary earned in all years
of employment and number of years worked

example: 1% of average monthly salary

during all years of employment for each
year employed,

an employee with 35 years employment

would receive 35% of average monthly
employment over employment career.
18-27

Amount of Benefits and Contributions

Defined Contribution Plans
1. Maximum allowable contribution to a defined
contribution plan varies with the type of plan
2. For a defined contribution pension plan, the
limit is 25% of years earnings, subject to a
dollar maximum that is adjusted for inflation
3. Dollar maximum was set at $30,000 in 1986
and will be adjusted for inflation when dollar
maximum for defined benefit plans reaches
$120,000
18-28

Amount of Benefits or Contributions

Defined Benefit Plans
1. Maximum benefit in a defined benefit plan
is 100% of employees earnings in three
consecutive years of highest earnings.
2. Dollar maximum for defined benefit was set
at $90,000 in 1988 and is adjusted for
inflation since that time.

18-29

Minimum Contribution or Benefit Top-Heavy Plans

1. For defined contribution plans, minimum
contribution is 3% of employee
compensation.
2. For defined benefit plan, minimum is the
contribution required to fund a benefit
equal to 2% of average compensation in 5
highest years times years of service.
Minimum benefit need not exceed 20%
of such average compensation.
18-30

Contribution for Keogh Plans

1. Keogh plans are subject to essentially the
same limitations, deductions and benefits
as applicable to corporate pension and
profit-sharing plans.
2. A special definition of earned income is
used to make contributions by selfemployed persons correspond to those for
a common-law employee.
3. Percentage limitations apply after the
contribution to the plan is deducted from
income.
18-31

Keogh Plan Contribution Illustrated

Partnership establishes a defined contribution
plan with 25% of employee compensation.
Partner earns $100,000.
Partners contribution is limited to 25% of
income after the contribution:
Taxable
Income
Employee
Owner

$40,000
80,000

Nontaxable
Contribution Total
$10,000
20,000

$50,000
100,000
18-32

Integrated Benefit Formulas

Integration: Adjusting for Social Security
1. Internal Revenue Code provides that the
employer may consider social security
benefits in setting contribution rates
2. Employer may contribute a higher percentage
for wages in excess of the maximum FICA
wage base than for wages below the base
3. Compensates for the fact that social security
provides a higher replacement rate for lowerpaid workers than for highly-paid workers
18-33

Integration Formulas
1. Excess Plan
Provides greater benefits on compensation
that exceeds wages subject to FICA tax.
2. Offset Plan
Provides benefits on employees full
compensation, but reduces benefits by a
percentage of social security benefit.

18-34

Maximum Contribution 401(k) Plans

1. Permit pretax contributions (called elective
deferrals) by employees.
2. Employees elect to contribute to a profitsharing plan and instruct employer to make
contributions on their behalf.
3. I.R.C. treats contributions as if they were
made by employer rather than by employee.
4. Limit on employee deferrals to 401(k) plan or
SEP is the lesser of 25% of compensation or
a dollar maximum (set at $7,000 in 1988 and
indexed for inflation since that time).
18-35

Maximum Contribution - Simple Plans

Eligible employees may choose to have the
employer make payments to the SIMPLE plan or
to receive these payments directly in cash.
Employee must be permitted to elect salary
reduction contributions, expressed as a
percentage of compensation for the year.
Employer must match contributions of
employees up to 3% or contribute a flat 2% of
compensation for each employee regardless
of whether the employee elects to participate.
The maximum annual pretax contribution an
employee may make under a SIMPLE is $6,000,
which will be indexed for inflation after 1997.
18-36

Nature of the Employers Promise

INVESTMENT RISK
Under defined contribution plan, employer
promises to make contributions to an account
that earns investment income.
Since benefits depend on contributions and
investment income, the employee bears the
investment risk in defined contribution plans.
Because the employee bears the investment
risk, he or she is likely to have some say in
how funds are invested.
18-37

Nature of the Employers Promise

INVESTMENT RISK
In a defined benefit plan, the employer
promises to provide a certain level of
retirement benefits to the employee.
Employer therefore bears the investment
risk in a defined benefit plan.

18-38

Advantages to Younger and Older Employees

1. A higher proportion of ultimate retirement
benefits are earned in early years of
participation in a defined contribution plan.
2. Present value of benefits promised to
younger workers under a defined benefit
plan tends to be small compared with
present value of benefits promised when
the worker is closer to retirement.

18-39

Forfeitures
1.

Forfeitures in defined contribution plans

may be used to reduce future employer
contributions or they may be reallocated
among participants.

2.

In a defined benefit plan, forfeitures may

be used only to reduce future employer
contributions.

18-40

Protection for Inflation

1. Defined benefit final average salary plans
provide greatest protection against inflation
since retirement benefits are based on
earnings immediately preceding retirement.
2. Career average plans base benefits on
employees salary throughout career.
3. Some plans provide cost-of-living
adjustments during retirement years, but this
is not common.
18-41

Other Benefits
Pre-Retirement Death Benefit
1.

Optional, except for contributory plans,

where employees contribution is payable as
death benefit.

2.

Some employers pay death benefit based on

employers contribution.

3.

Federal law requires payment of a qualified

preretirement survivor annuity to surviving
spouse of a vested participant.

4.

Some plans provide preretirement death

benefit through life insurance.
18-42

Other Benefits
Postretirement Death Benefits
1.

Survivor benefits may be provided by

annuities with joint and survivor options or
period certain payments.

2.

Federal law requires spousal consent for a

participant to elect out of the automatic
50% joint and survivor option.

18-43

Other Benefits
Disability Benefits
1.

Some plans treat disability as an early

retirement.

2.

More favorable approach provides for

continued contributions on behalf of a
disabled employee.

18-44

Distribution Requirements
1. Commencement of benefits: April 1 after
year in which individual reaches age 70 1/2
or the date of retirement, if later.
2. Distribution must be made over
the life of the participant or joint lives of
participant and spouse (i.e., an annuity).
the life expectancy of the participant and
his or her beneficiary.
18-45

Premature Distributions
10% penalty prior to age 59 1/2 except for
deductible medical expenses
in form of lifetime annuity
at age 55 by worker who meets plan
requirements for retirement

18-46

Taxation of Distributions
1. Retirement benefits traditionally paid to
participants in form of a lifetime annuity.
2. Installment distributions taxable only to the
extent they exceed employees investment
in the contract.
3. Lump-sum distributions may be rolled-over
into an annuity and taxed under installment
rules.
4. Lump-sum distributions that are not rolledover may be subject to five-year averaging.
18-47

Individual Retirement Accounts

1. A person who is not covered by an employersponsored plan can make tax-deductible
contribution to an IRA of $2,000 annually.
2. Persons covered by an employer plan may be
entitled to same deduction, a partial
deduction, or no deduction, depending on
income.
3. Persons not eligible for deduction may make
a nondeductible contribution.
4. New rules under TRA-97 allow a full $2,000
deductible contribution by a spouse who is
not employed outside the home.
18-48

Individual Retirement Accounts

Adjusted Gross Income Phase Out Levels
$25,000 to $35,000 for single taxpayers
$40,000 to $50,000 for married filing jointly
0 to $10,000 for married filing jointly
TRA-97 gradually increases AGI phase-out
levels to double the present level by 2007.

18-49

IRA Taxation Formula

Amount
Distributed X
From IRA
During Year

Total
Nondeductible
Contributions All
Years to IRAs
Fair Market Value
of all IRAs at
End of Year

Tax-Free
Withdrawals
in Prior Years

Amount Distributed
From IRA During
the Year

18-50

The New Roth IRA

Beginning in January of 1998, contributions
permitted to Roth IRA
contributions only on a non-deductible basis.
earnings tax-free when the funds are
withdrawn for retirement (i.e., after age 59).
annual contributions of $2,000 (100% of
compensation) per individual.
AGI phase-out $95,000 single $150,000 joint.
no requirement for withdrawals at 70 and
contributions may continue after age 70.
$2,000 limit for Traditional IRA and a Roth IRA.
18-51

Education IRA
Introduced by TRA-97 - despite its designation, has
nothing to do with retirement.
designed for saving for higher education.
up to $500 annually per student (to age 18).
phased out for joint filers - $150,000 to $160,000,
$95,000 and $110,000 for single taxpayers.
nondeductible, but earnings tax-free.
distributions under age 30 not taxable if used for
qualified higher education expenses.
distributions in excess of qualified education
expenses taxable with a 10% penalty.
Education IRA contributions are in addition to
Roth IRA Plus and traditional IRAs.
18-52