Variable, Indexed, and Market-Value Adjusted Annuities Flashcards
5 aspects of Variable Annuities
- A variable annuity makes no guarantee as to the annuity principal or the credited interest rate - owners assume risk.
- As with variable life insurance, variable annuity premiums and contract values are invested in the insurer’s separate account instead of its general account and adjust in response to the investment performance of their associated stock, bond, and money-market portfolio subaccounts
- 20-30 different subaccounts is common ranging from conservative money-market portfolios to risky and aggressive international and sector stock portfolios.
- Variable contract owners are free to reallocate premiums (and account values) among any of the insurer’s available subaccounts.
- Most variable annuities sold today are deferred annuities.
Variable Annuity Accumulation Units
A variable account value is equal to _____ x _____?
Accumulation units are equal to the ____________.
The growth of a variable annuity’s account value during its accumulation period is measured in terms of accumulation units.
At any point in time, a variable contract’s account value is equal to the total number of accumulation units multiplied by the NAV at that moment.
- When the annuity owner makes premium payments and allocates them among the contract’s subaccounts, they are used to buy accumulation units.
- Accumulation units are equal to the subaccount’s net asset value, or NAV.
A simple example will illustrate this important aspect of variable contracts. Jean buys a variable annuity and directs her $2,500 premium deposit into the contract’s blue-chip stock subaccount. She does this at a time when each accumulation unit (i.e., NAV) in that subaccount is valued at $10. This means that Jean bought 250 accumulation units of that subaccount ($2,500 ÷ $10 = 250).
One year later, because of the positive performance of the stocks in that subaccount, the NAV of the blue-chip stock accumulation unit rises to $12.20. As a result, the value of Jean’s investment in that subaccount is now $3,050 ($12.20 × 250). If Jean decides then to invest her $2,500 annual premium into that subaccount, she would acquire 205 accumulation units ($2,500 ÷ 12.20). She would then own a total of 455 accumulation units in the blue-chip stock subaccount for a current value of $5,550.
Why do income payments change in a Variable Annuity Annuitization?
Variable annuitization (settlement option) provides for income payments that are not fixed, income payments change in response to the performance of the contract’s underlying subaccounts.
However, determining the payment amount of each payment is very different with a variable annuity and involves four steps:
- Determine the assumed interest rate (AIR).
- Use the AIR to calculate the first annuity payment amount.
- Convert the first annuity payment amount into a set number of annuity units.
- Determine future annuity payment amounts by multiplying annuity units by the current NAV.
The contract owners are able to choose their own Assumed Interest Rate which is usually what?
A basic factor in any annuity’s calculation of the payment amount is the interest rate at which the undistributed funds will grow while income payments are being distributed.
To solve this problem, insurers use an assumed interest rate (AIR) when annuitizing a variable annuity. The AIR is the rate of return that the contract’s values are assumed to earn over the annuitization period.
Insurers let the contract owners select the rate, and usually offer a couple rates to choose from (e.g., 3 percent and 5 percent).
Based on the AIR and the payout option selected, the annuity purchase rate is determined. (Recall that the annuity purchase rate is the amount of ongoing income that every $1,000 of a contract’s accumulated value provides.)
After the first month’s payment is caluclated using the ______, the payment is then converted to Annuity Units by dividing by the current unit value?
After calculating the first month’s payment amount (using the selected AIR), the payment amount is converted into annuity units.
by dividing the initial payment by the accumulation unit values.
To illustrate, assume that a variable annuity contract owner recently annuitized the contract and the first monthly payment was $2,000. Further assume that the annuity unit value at the time of annuitization was $10.
The $2,000 first payment, divided by $10, equates to 200 annuity units. This number stays constant—this contract will forever have 200 annuity units as the basis of future annuity payments.
While the number of annuity units is fixed, their value will vary over the annuitization period just as the net asset value of each subaccount continually changes.
All future income payments amounts are determined by multiplying the annuity units (200 units in this example) by the current NAV.
Continuing our example from above, if the annuity unit value in the second month is $10.15, then the annuitant will receive a payment of $2,030 (200 units × $10.15). However, if the unit value decreases to $9.75, then the payment will be $1,950 (200 units × $9.75).
Impact of AIR on Future Annuity Payment Amounts
And should you select a higher AIR or a lower AIR?
Which one more easily allows you to generate the same or higher future payments?
Future changes in the annuity payment amount are influenced by the assumed interest rate as well as changes in the subaccount net asset value NAV.
If the NAV change equals the AIR, then there would be no change in the annuity income amount (since the actual rate of return equals the assumed rate).
A higher AIR produces a larger initial payment but requires a higher investment return to maintain the payment amount.
A lower AIR produces a lower initial payment but more easily enables the contract to generate the same or higher future payments.
Name 3 Variable Annuity Contract Charges and Fees
Variable annuities impose several charges and fees unique to the product. Depending on the fee and the terms of the contract, these costs are handled in one of two ways:
- They are either deducted from the premium payments before the payments are deposited into the separate subaccounts.
- They are deducted from the values in the subaccounts.
The types of charges and fees common to variable annuities include:
- mortality and expense (M&E) costs—These are the insurance-related costs for a variable annuity. They cover the cost of the contract’s death benefit.
- fund management fees—These charges cover the cost of managing and administering the separate subaccount investment portfolios.
- annual contract fee—This charge is assessed every year by the insurer. It covers the cost of administering and handling the contract.
Variable Annuity Death Benefits equals the greater of …
Like fixed annuities, variable annuities provide for a death benefit if the owner or annuitant dies before the contract’s funds are annuitized.
This is the one aspect of variable annuities that, under most contracts, is guaranteed.
Under most variable annuities, the death benefit equals the greater of
- the premiums paid into the policy (less any withdrawals) or
- the contract’s accumulated value at the time of death.
Many variable annuity contracts offer the option of increasing the death benefit as the contract’s values grow.
This feature requires a higher M&E charge.
Name the 2 bodies that oversea the Regulation of Variable Annuities?
Name the 2/3 requirements to sell variable annuities.
The Securities Exchange Commission (SEC) is responsible for regulating the securities that make up an insurer’s separate account.
The Financial Industry Regulatory Authority (FINRA), formerly known as the National Association of Securities Dealers (NASD), regulates producers who sell variable insurance products.
- To be properly registered to sell variable insurance contracts, producers must hold either a FINRA Series 6 or Series 7 registration
- They must also hold a valid life insurance license in the state(s) where they do business.
- Some states also require a state-issued variable life or variable producer’s license.
What is an EIA?
But they are not _________ contracts.
EIA’s can only _________ in value; they can never _____ value.
EIAs allow contract owners to participate in some of the growth in the stock market while ________ possible _______ to principal.
They do so by:
- linking the interest return to _______
- providing for a ___________ __________ rate of return for the length of the contract.
Equity-indexed annuities (EIAs), or indexed annuities, are tied closely to the performance of a stock index,
But they are not variable contracts.
Equity-indexed annuities can only increase in value; they cannot lose value.
EIAs allow contract owners to participate in some of the growth in the stock market while avoiding possible losses to principal.
They do so by:
- linking the interest return to an equity (stock) index, and
- providing for a guaranteed minimum rate of return for the length of the contract.
For example, let’s say that Long Life Insurance Company’s equity-indexed annuity is tied to the S&P 500. When Earl bought his EIA with a $10,000 premium deposit, the S&P 500 was at 1000. At the end of the contract’s first term one year later, the S&P was at 1100. This is an increase of 10 percent in the index. Therefore, the basis for the amount of interest to be credited to Earl’s contract is 10 percent. However, the actual amount credited depends on the contract’s participation rate and rate cap.
EIA Participation Rates and Caps
An EIA participation rate is the percentage of the index increase that is actually credited to the annuity. These rates typically range from 60 to 90 percent. Returning to our example, the increase in the S&P 500 during the contract’s term was 10 percent. If the participation rate for Earl’s contract is 75 percent, then 75 percent of the 10 percent index increase (7.5 percent) is the amount of interest that is credited to his contract. For that period, Earl’s contract was credited with $750 ($10,000 × .075).
In addition, an EIA may have a rate cap. A rate cap is the maximum interest rate that is applied to the funds in the EIA if the percent of change in the index is greater than the cap. A cap of 14 percent, for example, limits the amount of interest credited to an EIA to 14 percent. This is true regardless of whether the participation rate applied to the index increase produces a higher rate.
EIA Minimum Interest Rates
Underlying an EIA contract for its entire term is a minimum guaranteed rate of interest. At the end of the term, the greater of the index performance (modified by the participation rate and cap rate) or the minimum guaranteed rate is credited to the contract. The minimum interest guarantee (which is usually around 3 percent) provides the assurance that EIA’s principal is secure and the account value will grow by a minimum amount. (Because of this protection of principal, most EIAs are classified as a form of fixed annuity.)
The typical term of most EIAs on the market today is five to seven years. At the end of the term, the accumulated values can be taken free of surrender charge. Or, they can be left in the contract and the contract can be continued for another term.
EIA Death Benefits
Like declared-rate fixed and variable annuities, equity-indexed annuities provide a death benefit if the annuitant or contract owner dies before the contract annuitizes. The death benefit is usually specified as either the contract’s accumulated index value or the guaranteed minimum value—whichever is higher. The death benefit is payable to the contract’s beneficiary.
What is a MVA?
What is the risk associated with an MVA?
Unlike an EIA, an MVA annuity offers an interest rate __________ feature that makes it possible for the MVA contract value to _____ money if the contract is surrendered before the end of its term.
Another annuity design with a market-linked rate feature is the market-value adjusted (MVA) annuity.
Unlike an EIA, an MVA annuity offers an interest rate adjustment feature that makes it possible for the MVA contract value to lose money if the contract is surrendered before the end of its term.
Recall that equity-indexed annuities cannot lose value.
At the end of the term the contract owner may
- renew the contract term to stay with the same rate (likely if the contract rate is higher than current rates),
- move to another contract period with an adjusted current rate (likely if the contract rate is lower than current rates), or
- withdraw funds without a surrender charge.
Funds withdrawn before a contract period ends are subject to a market-value adjustment as well as a surrender charge.
The MVA is an investment vehicle that exposes contract owners to investment risk, so it is classified as a security. As such, producers who sell MVAs must be registered with FINRA.
KEY POINTS
- Variable annuity contract owners fully assume the investment risk of the annuity’s contract value in the insurer’s separate account.
- The growth of a variable annuity’s account value during its accumulation period is measured in terms of accumulation units.
- At any point in time, a variable contract’s account value is equal to the total number of accumulation units multiplied by the NAV at that moment.
- Insurers use an assumed interest rate (AIR) when annuitizing a variable annuity. The AIR is the rate of return that the contract’s values are assumed to earn over the annuitization period.
- A higher AIR produces a larger initial payment but requires a higher investment return to maintain the payment amount.
- A lower AIR produces a lower initial payment but more easily enables the contract to generate the same or higher future payments.
- Equity-indexed annuities (EIAs), or indexed annuities, are tied closely to the performance of a stock index, but they are not variable contracts. EIAs allow contract owners to participate in some of the growth in the stock market while avoiding possible losses to principal.
- Unlike an EIA, a market-value adjusted annuity offers an interest rate adjustment feature that makes it possible for the MVA contract value to lose money if the contract is surrendered before the end of its term.
