18-1 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.

18-2 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

18-3 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

18-4 Tax Treatment of Annuities InvestmentNontaxable Payment X in Contract = Return of Expected ReturnCapital $6,000 = $60,000 = $60,000 ($500 X 12) X 15 $90,000 $6,000 X $60,000 = $4,000 $90,000

18-5 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.

18-6 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

18-7 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

18-8 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.

18-9 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.

18-10 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.

18-11 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.

18-12 CREF Performance Unit YearValue 1952$

18-13 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

18-14 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 Usually, the longer the guarantee period, the lower the guaranteed rate.

18-15 Annuities - Surrender Charges 1.Although some insurers still use a front- end 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.

18-16 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.

18-17 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 employer’s contribution or investment earnings until benefits are distributed.

18-18 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.

18-19 Qualification Requirements 1.Designed for exclusive benefit of employees. 2.In writing and communicated to employees. 3.Must meet one of several vesting schedules. 4.Cannot discriminate in favor of officers, stock- holders 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.

18-20 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

18-21 Types of Qualified Plans 1.Defined Benefit Pension Plans 2.Defined Contribution Pension Plans 3.Qualified Profit-sharing Plans 4.Employee Stock Ownership Plans 5.Section 401(k) Plans 6.Simplified Employee Pensions 7.Keogh Plans 8.Section 403(b) Plans 9.SIMPLE IRAs and SIMPLE 401(k) plans

18-22 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).

18-23 Employee Contributions 1.When employees contribute to a profit- sharing 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.

18-24 Amount of Benefits or Contributions Defined Contribution Plans 1.Work exactly as the name implies: employer’s contribution is set by the employment agreement 2.Contribution is usually a percentage of compensation, such as 5% or 10% of employee wages

18-25 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 employee’s salary, the benefit accrual rate, and employee’s years of service 3.Most plans are final average salary plans but some are career average salary plans.

18-26 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

18-27 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.

18-28 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 year’s 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

18-29 Amount of Benefits or Contributions Defined Benefit Plans 1.Maximum benefit in a defined benefit plan is 100% of employee’s 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.

18-30 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.

18-31 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 self- employed persons correspond to those for a common-law employee. 3.Percentage limitations apply after the contribution to the plan is deducted from income.

18-32 Keogh Plan Contribution Illustrated Partnership establishes a defined contribution plan with 25% of employee compensation. Partner earns $100,000. Partner’s contribution is limited to 25% of income after the contribution: Taxable Nontaxable Income ContributionTotal Employee$40,000$10,000$50,000 Owner80,00020,000100,000

18-33 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 lower- paid workers than for highly-paid workers

18-34 Integration Formulas 1.Excess Plan Provides greater benefits on compensation that exceeds wages subject to FICA tax. 2.Offset Plan Provides benefits on employee’s full compensation, but reduces benefits by a percentage of social security benefit.

18-35 Maximum Contribution 401(k) Plans 1.Permit pretax contributions (called “elective deferrals”) by employees. 2.Employees elect to contribute to a profit- sharing 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).

18-36 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.

18-37 Nature of the Employer’s 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.

18-38 Nature of the Employer’s 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.

18-39 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.

18-40 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.

18-41 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 employee’s salary throughout career. 3.Some plans provide cost-of-living adjustments during retirement years, but this is not common.

18-42 Other Benefits Pre-Retirement Death Benefit 1.Optional, except for contributory plans, where employee’s contribution is payable as death benefit. 2.Some employers pay death benefit based on employer’s 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.

18-43 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.

18-44 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.

18-45 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.

18-46 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

18-47 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 employee’s 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 rolled- over may be subject to five-year averaging.

18-48 Individual Retirement Accounts 1.A person who is not covered by an employer- sponsored 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.

18-49 Individual Retirement Accounts Adjusted Gross Income Phase Out Levels $25,000 to $35,000for single taxpayers $40,000 to $50,000for married filing jointly 0 to $10,000for married filing jointly TRA-97 gradually increases AGI phase-out levels to double the present level by 2007.

18-50 IRA Taxation Formula Total NondeductibleTax-Free AmountContributions All _ Withdrawals Distributed X Years to IRAs in Prior Years From IRAFair Market ValueAmount Distributed During Year of all IRAs at + From IRA During End of Yearthe Year

18-51 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 59½).  annual contributions of $2,000 (100% of compensation) per individual.  AGI phase-out $95,000 single $150,000 joint.  no requirement for withdrawals at 70½ and contributions may continue after age 70½.  $2,000 limit for Traditional IRA and a Roth IRA.

18-52 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.