FIXED INDEXED ANNUITY (FIA)

FIA Planning for Secured Financial Future

Good planning requires that when client is still able, individual or family should estimate the amount of income they will need to live a comfortable lifestyle allowing them to do whatever they and their family, spouse and business leaders want to do. Are they going to want an extravagant lifestyle? Or are they going to want a somewhat comfortable lifestyle that will allow them to do the community work they have always wanted to do? We can help by assuring them that FIA can help them realize the dreams they hold for the rest of their life.

TWO LAYERS OF SAFETY

From a safety standpoint, the FIA is a vastly different vehicle than a mutual fund or variable annuity. First, the return of principal on the FIA contract is guaranteed by the insurer, along with a modest rate of interest. Linking to the index does not put these minimum guarantees at risk, so the SEC does not classify them as securities. Because of the presence of these two guarantees, the various state insurance guarantee funds stand behind the EIA.

This double level of safety nets, from the insurer and the state fund, make these vehicles appropriate for people with lower risk tolerance or as the lesser-risk parts of an overall accumulation plan for the more aggressive client. People nearing retirement may find these FIA products especially attractive, as the guarantees will preserve principal and a little yield, but the potential for gaining some up-side appreciation in a rising market is still there. IRA and pension plan rollovers, where the client does not need money until years in the future, may be great places to use a Fixed Index Annuity.

STATE GUARANTEE FUND

Safety is a primary factor that causes clients to invest in fixed annuities, because of the safety nets that make them a good fit for situations where risk of loss is inappropriate. One attractive aspect of the fixed annuity is the second line of security beyond the safety of the insurer itself. Each state has created a state guarantee fund that provides underlying security to fixed products owned by the state’s residents. How these funds are paid for goes back to basic insurance law:

INSURANCE COMPANIES MUST CONTRIBUTE TO THE STATE'S GUARANTEE FUND

If an insurance company is authorized to do business within a state, the cost of admission is more than just the costs of the examination and filing fees. Each insurance company must begin paying into the state’s guarantee fund relative to the business in force as it grows within the state.

HOW ANNUITIES DIFFER FROM BANK ACCOUNTS

As banks, annuities can receive a lump sum deposit or ongoing deposits, and the money can be withdrawn. However, annuities differ from bank accounts in two important ways:

1. The interest or accumulated earnings within the annuity are not taxed each year but are taxed later when the money is taken out of the annuity or the annuity is annuitized. This is referred to as tax-deferred growth. Tax deferred growth enables interest to compound (interest earns interest) without taxes.

2. An annuity contract can pay out a stream of payments, through annuitization. These payments could exceed the original purchase and interest that had accumulated up to the time of annuitization, and they could continue for many years, up until the death of the annuitant or later. Compared to bank savings accounts, where the money could run out before the account owner dies, annuities could pay out an income for life.

3.Annuities also bypass probate when funds are to be distributed to annuitants and beneficiaries. When someone dies, assets may typically be tied up, and no one has access to them until the estate settlement is completed. This legal probate process can take many months and years to finish; however, like life insurance, annuities can pay out funds quickly by bypassing the probate process.

4. The tax-deferred growth and guaranteed life income can’t be offered by any bank account and are the main reasons annuities are attractive to people who are saving money for retirement.

ANNUITIZATION

Annuitization is the process of converting a lump sum of money, often from a retirement account or an annuity, into a stream of regular, fixed income payments. This provides a guaranteed income for a specific period or for life, helping to ensure financial stability, but it also means sacrificing control and access to the original lump sum. The owner chooses a pay-out option to receive income from his annuity in consideration for all of the cash value buildup

ANNUITY PAYOUT CHOICES

Combined options: It's also possible to combine options, such as receiving payments for life with a "period certain" backstop to ensure a certain number of payments are made if you die early.

1 ANNUITY PAYOUT CHOICE ONE WITH: EXAMPLE Pure/Straight Life Annuity: An annuity with a guaranteed payout for the life of the annuitant. That is, payments are made for the rest of the annuitant's lifetime.

Example: Pure life annuity/ straight life This choice has the highest possible payout, and also the maximum risk and reward trade off. It will pay the annuitant, say monthly or annually, for the rest of his life, so if he celebrates his birthday among the centenarians, he will have taken significantly more out of the insurance company than all the proceeds and interest ever credited to him. The risk is that if he dies a year later in a car crash, the company will keep the remainder.

ANNUITY PAYOUT CHOICE: TWO WITH EXAMPLE

Life Annuity with Period Certain (combined): An annuity with a guaranteed payout for the life of the annuitant or a given length of time, whichever is longest. Payments are guaranteed for a specific number of years, such as 10 or 20 years. If the annuitant dies before the period ends, payments continue to their beneficiary for the remaining term. Example: Life with 10 years certain If the annuitant dies unexpectedly within the next few years, this option provides a string of payments that will continue until the beneficiary and the annuitant together have received the full 10 years of benefits. If the annuitant survives until year 16, the 10-year guarantee is passed and the annuity continues to pay the annuitant at the same rate, so the stream of dollars continues and only the guarantee to an heir goes away. This guarantee period can be longer, such as “Life and 20,” but the longer the guarantee, the more the monthly payouts are reduced.

3 ANNUITY PAYOUT CHOICE THREE WITH EXAMPLE

Refund Annuity: An annuity which pays a refund for all the principal and interest not yet used at the time of the annuitant’s death.

Example: Life with a refund Whenever the annuitant dies, a refund for all the principal and interest not yet used in his lifetime goes to a named beneficiary. The annuitant can elect for the payment to be issued in a continuing stream, or as a lump sum. When he has used up the principal and interest in payments, there is nothing left to pass on.

ANNUITY PAYOUT CHOICE: FOUR WITH EXAMPLE

Joint and survivor: An annuity in which payments are made for the lives of two people (e.g., a married couple) and continue until the second person dies. Example: Joint and 100% Survivor life In this option, the annuitant lists Carol, his wife, as the joint life. The annuity is now calculated on their joint life expectancies, with Carol expected to survive him because she is a female. However, it pays until the second one dies, regardless of who dies first. The insurer’s potential payout risk is increased substantially. In the event that the annuitant owned substantial life insurance on himself, he could elect a Joint and 2/3 survivor or Joint and 50% survivor option. These would reduce the payouts on the death of either party but increase the overall payout.

5 ANNUITY PAYOUT CHOICE FIVE WITH EXAMPLE Period Certain Annuity: An annuity with a payout option in which funds are liquidated over a set period of time. First, how do period certain annuities work, and how are they taxed? To begin with, a period certain annuity employs a payout option in which funds are liquidated over a given period of time. Perhaps the annuitant wishes the funds to be paid out in five years to fund college, or in 10 years to cover an income gap while he or she works in a low wage but satisfying position before taking a company pension later on. The annuitant elects, for example, “10 years period certain.”

The insurance company looks at the interest rates it expects to earn over the next decade, investing for a longer time frame because these monies will indeed be tied up over that decade. Then, it quotes a price to the applying annuitant that reflects repayment of all the capital put into the annuity, plus the interest that the company will spread evenly over the 10 years.

GOOD SITUATIONS FOR PERIOD CERTAIN ANNUITIES

FILL A GAP

One scenario is when the annuity payment stream can “fill a gap” in income. For instance,

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Harry retires from his high-pressure position as a stockbroker at age 50. He has accumulated a substantial pot of money in his 401(k) account and also with some deferred compensation from the brokerage firm. However, he has wanted to do mission work in the Native American reservations of Arizona. His compensation is quite modest in that endeavor.

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Veronica decides to liquidate $500,000 from her personal stock portfolio and use it to buy a “10-year period certain” annuity. The cash flow from that will support her family in a better lifestyle over the next 10 years than her small salary alone. Then, at 60, she will retire from mission work and begin to liquidate her pension plan. That allows the contributions in her deferred compensation and 401(k) plans to grow over the next ten years until she accesses them, so she can reap the benefits of that deferred payoff in addition to supplementing her present-day income.

b THE STRUCTURED SETTLEMENT A Payout option, of a large lump sum of money such as in litigation, that pays the recipient over a period of time, instead of at once. Annuities are often used to fund this type of settlement. Individuals often are given a large amount of money, sometimes for several millions of dollars. The negative consequences are the costs for the payor, the taxes to the payee, and the payee’s difficulty of managing large amounts of money, which often leads them to become broke. Instead of receiving large lump sums, immediate annuities are used to help lower the cost to the payor yet provide a way to spread out the income and taxes over a long period of time for the payee.

The most common structured settlements are for:

Lottery Payments: Instead of large lump sum, usually a 20-year annuity payout is used.

Lawsuit settlement: Often for personal liability or medical malpractice awards, annuity income is paid for pain and suffering, loss of income, and health care needs. Professional sports contracts: Usually a deferred compensation component to pay the athlete an income after their sports career ends, using a deferred annuity to fund it.

CAUTION: While these features may be attractive, purchasers for retirement, college education, charitable planning, and structured settlement should be aware of income taxes, tax penalties, and annuity surrender charges before purchasing.

Example: Structured settlement

Sara, age 15, is injured in a school bus accident where the driver’s negligence was to blame. She sues for damages. When the insurance company representing the bus company and school board suggests a settlement, they ask if Sara and her family would accept a 10-year structured payment rather than an immediate lump sum.

On considering the fact that the income stream could help Sara through college and provide a nice continuing nest egg for her first years in the workforce, the family agrees to accept a 10-year payment. The sued company then shops the total payout to insurance companies and buys a 10-year period certain annuity with today’s discounted dollars. Even though the total dollars paid over the years may be a little higher than the lump sum would have been, the bus company is still writing a smaller check to the insurance company to buy the period certain annuity than it would have written in a lump sum today.

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LOTTERY PAYOUTS

Another popular use for the period certain annuity is the lottery. Many lotteries will have payout methods that pay a fixed amount over time. For instance, a $2 million dollar winner gets $100,000 a year over the next 20 years. Again, in a manner similar to the structured settlement program, the state sponsoring the lottery buys the 20-year payout with a discounted check today. Now the state’s obligation and paperwork are done.

Example

Period Certain Annuity

The annuitant is the person on whose life the annuity depends. If Morty Krause is 60 years old at the time he takes a period certain annuity payment option, he is the person who will receive the payouts. He can name a beneficiary who receives any remaining payments if he dies before the 10-year payment period is completed. However, the age of Morty in this situation is irrelevant. The insurer is looking at the interest rates only. In this case, Morty elects a “10-year period certain” annuity using $100,000 of nonqualified, after-tax dollars.

Looking at expected interest rates, the company figures a projected interest rate and quotes Morty a figure of $16,500 per year over the decade. Morty will get an exclusion allowance, described above, so that each year his taxes are based on receiving his original funds back in $10,000 installments. Additionally, the $6,500 which will not vary (the payout was in a guaranteed fixed option) will be reported as taxable interest. By the last payment at the end of year 10, Morty has exhausted both his own and the company’s money. The payment stream stops, the agreement ends, and nothing is left for a named beneficiary to inherit.

In the event that Morty selected a life income option of any type instead of the period certain option, the actuaries would figure his age and gender as factors because they are predicting his average life expectancy. In the event that Morty rolls over a tax-deducted retirement account from a previous job to create the “10-year period certain” in a rollover IRA, he would receive the same benefit and payout. However, now 100% of the payments for principal and interest are taxed, as the contributions to the annuity have not yet been taxed.