Annuities For Dummies by Kerry Pechter Annuities For Dummies® Published by Wiley Publishing, Inc 111 River St Hoboken, NJ 07030-5774 www.wiley.com Copyright © 2008 by Wiley Publishing, Inc., Indianapolis, Indiana Published by Wiley Publishing, Inc., Indianapolis, Indiana Published simultaneously in Canada No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning, or otherwise, except as permitted under Sections 107 or 108 of the 1976 United States Copyright Act, without either the prior written permission of the Publisher, or authorization through payment of the appropriate per-copy fee to the Copyright Clearance Center, 222 Rosewood Drive, Danvers, MA 01923, 978-750-8400, fax 978-646-8600 Requests to the Publisher for permission should be addressed to the Permissions Department, John Wiley & Sons, Inc., 111 River Street, Hoboken, NJ 07030, 201-748-6011, fax 201-748-6008, or online at http://www.wiley.com/go/permissions Trademarks: Wiley, the Wiley Publishing logo, For Dummies, the Dummies Man logo, A Reference for the Rest of Us!, The Dummies Way, Dummies Daily, The Fun and Easy Way, Dummies.com and related trade dress are trademarks or registered trademarks of John Wiley & Sons, Inc and/or its affiliates in the United States and other countries, and may not be used without written permission All other trademarks are the property of their respective owners Wiley Publishing, Inc., is not associated with any product or vendor mentioned in this book LIMIT OF LIABILITY/DISCLAIMER OF WARRANTY: The publisher and the author make no representations or warranties with respect to the accuracy or completeness of the contents of this work and specifically disclaim all warranties, including without limitation warranties of fitness for a particular purpose No warranty may be created or extended by sales or promotional materials The advice and strategies contained herein may not be suitable for every situation This work is sold with the understanding that the publisher is not engaged in rendering legal, accounting, or other professional services If professional assistance is required, the services of a competent professional person should be sought Neither the publisher nor the author shall be liable for damages arising herefrom The fact that an organization or Website is referred to in this work as a citation and/or a potential source of further information does not mean that the author or the publisher endorses the information the organization or Website may provide or recommendations it may make Further, readers should be aware that Internet Websites listed in this work may have changed or disappeared between when this work was written and when it is read For general information on our other products and services, please contact our Customer Care Department within the U.S at 877-762-2974, outside the U.S at 317-572-3993, or fax 317-5724002 For technical support, please visit www.wiley.com/techsupport Wiley also publishes its books in a variety of electronic formats Some content that appears in print may not be available in electronic books Library of Congress Control Number: 2007941625 ISBN: 978-0-470-17889-8 Manufactured in the United States of America 10 About the Author Kerry Pechter is the senior editor of Annuity Market News As a reporter who writes about annuities and the annuity industry full-time and as a former marketing writer who specialized in annuities at The Vanguard Group, he brings both an outsider’s and an insider’s perspective to the writing of this book A financial journalist for many years, Kerry has written for the New York Times, the Wall Street Journal, the Los Angeles Times, and many other national and regional publications His previous books include two career guides, A Big Splash in a Small Pond: How to Get a Job in a Small Company (Fireside) and An Engineer’s Guide to Lifelong Employability (IEEE) He is a graduate of Kenyon College Dedication To my family — my supportive and resourceful wife, Lisa Higgins; my three wonderful daughters, Hannah, Ariel, and Mattea; my brother, David, and his wife, Jean; my sister, Carol, and her husband, Andy; and my parents, Allen and Dorothy Author’s Acknowledgments The community of people who think about, write about, create, and sell annuities is a relatively small one Many of its members patiently guided me through the intricacies of these odd but necessary insurance products when I was figuratively climbing stairs in the dark A special thanks goes to Noel Abkemeier, Jeremy Alexander, Lisa Bennett, Garth Bernard, Scott DeMonte, Howard Drescher, Jerry Golden, Pem Guerry, Kelli Hueler, David Macchia, Moshe Milevsky, Lisa Tibbitts, Tamiko Toland, John Ziambras, the folks at NAVA (Mark Mackey, Deborah Tucker, and Kathleen McKee), and to the media relations professionals at dozens of insurance companies who cheerfully responded to my last-minute requests for information I’m grateful to Adam Reinebach and Lee Barney, the publisher and editor of Annuity Market News, respectively, for supporting this project and for sharing my editorial values I am also indebted to my former colleagues at The Vanguard Group, who taught me the true fundamentals of investing Thanks to my agent, Marilyn Allen, my acquisitions editor, Stacy Kennedy, and my project editor, Natalie Harris, for recognizing the value of publishing this book and welcoming me into the fold I’d also like to thank my friend and fellow Dummies author, Russ Wild, for his indispensable help Finally, I owe a huge debt to Jesus Salas for his wise counsel Publisher’s Acknowledgments We’re proud of this book; please send us your comments through our Dummies online registration form located at www.dummies.com/register/ Some of the people who helped bring this book to market include the following: Acquisitions, Editorial, and Media Development Project Editor: Natalie Faye Harris Acquisitions Editor: Stacy Kennedy Copy Editor: Pam Ruble Technical Editor: Ron Hanson Editorial Manager: Christine Meloy Beck Media Development Manager: Laura VanWinkle Editorial Assistants: Leeann Harney, David Lutton, Erin Calligan Mooney, Joe Niesen Cartoons: Rich Tennant (www.the5thwave.com) Composition Services Project Coordinator: Katie Key Layout and Graphics: Reuben W Davis, Alissa D Ellet, Melissa K Jester,Christine Williams Proofreaders: Jessica Kramer, Bonnie Mikkelson Indexer: Broccoli Information Management Publishing and Editorial for Consumer Dummies Diane Graves Steele, Vice President and Publisher, Consumer Dummies Joyce Pepple, Acquisitions Director, Consumer Dummies Kristin A Cocks, Product Development Director, Consumer Dummies Michael Spring, Vice President and Publisher, Travel Kelly Regan, Editorial Director, Travel Publishing for Technology Dummies Andy Cummings, Vice President and Publisher, Dummies Technology/General User Composition Services Gerry Fahey, Vice President of Production Services Debbie Stailey, Director of Composition Services Contents Title Introduction About This Book Conventions Used in This Book What You’re Not to Read Foolish Assumptions How This Book Is Organized Icons Used in This Book Where to Go from Here Part I : Annuities: A Blend of Insurance and Investment Chapter 1: Making Sense of Annuities Annuities: Older Than You (Probably) Think They Are Should You Get an Annuity? Raising Your Awareness Seeing How Annuities Work Chapter 2: Using Annuities to Meet Retirement Challenges Calculating Retirement Risks and Solutions Countering the Main Risks of Retirement Chapter 3: Dissecting an Annuity Examining the Elements of Annuities Telling One Annuity from Another The Life Cycle of All Annuities Chapter 4: Weighing the Pros and Cons of Annuities Evaluating Annuity Pluses Confronting the Annuity Negatives Comparing Annuities with Their Competition Chapter 5: Deciding Whether an Annuity Is Right for You Who Should Own an Annuity? Preparing for the “Suitability” Test Part II : Identifying the Main Types of Annuities Chapter 6: Saving with Fixed Annuities How Fixed Annuities Work Examining the Main Types of Fixed Annuities Pros and Cons of Fixed Annuities Buying a Fixed Annuity Managing Your Fixed Annuity Chapter 7: Experimenting with Index Annuities Defining Index Annuities Seeing How Index Annuities Work Comparing Types of Index Annuities Looking at the Pros of Index Annuities — and Avoiding the Cons Tracking Index Annuity Performance Why You Should Consider Waiting Chapter 8: Meeting the New Generation of Variable Annuities (VAs) Defining VAs Pros and Cons of VAs Getting to Know GLBs Chapter 9: Financing Your Retirement with an Income Annuity Generating Income with an Annuity Buying and Paying for an Income Annuity Getting Your Money’s Worth Customizing Your Income Annuity Chapter 10: Aging Gracefully with an ALDA Insuring Your Old Age: What ALDAs Do How ALDAs Work Pros and Cons of ALDAs Longevity Risk: The Reason for ALDAs Paying for an ALDA Shopping for an ALDA Glossary Accumulated value: The sum of the premium and the earnings in an annuity contract, minus fees charged to the contract and withdrawals from the contract Accumulation period or savings period: The period during which the owner of a deferred annuity makes payments into the contract and accumulates assets Accumulation unit value (AUV): A variable annuity subaccount’s unit of measure, similar to a mutual fund’s net asset value (NAV) During the accumulation period, the AUV fluctuates daily with a change in the value of the subaccount (similar to a mutual fund) Annuitant: The person (or persons) whose life expectancy is used to calculate the value of annuity payments The contract owner and the annuitant are often, but not always, the same person Annuitization: The conversion of the accumulated value of the contract into a stream of monthly, quarterly, or semiannual payments, for as long as one or two persons is living, or for a specific number of years Annuity commencement date, annuity starting date: The date when income payments begin Annuity contract: The legal agreement between the annuity contract owner and the insurance company that issues the contract Annuity payout period: The period of time, starting on the annuity commencement date, during which the insurance company makes annuity payments Annuity unit value: The measurement used to determine the amount of each annuity payment to the owner of a variable income annuity The number of units is established when the annuity is first converted to an income stream or purchased The annuity unit value fluctuates with the value of the underlying investments A-Share variable annuities: Variable annuity contracts whose purchaser pays a sales charge or load at the time of purchase A-Share contracts have no surrender charges or surrender periods, and may have lower insurance charges (M&E charges) than other types of contract share classes Asset allocation: The method of diversifying a portfolio by dividing the assets among investments in stocks, bonds, and cash investments By changing the asset allocation (that is, the proportion of stocks to bonds to cash), the investor can increase or decrease the risk of the portfolio and influence its probable long-term returns Asset allocation funds: Mutual funds that offer the investor a pre-established asset allocation Someone who invests in a deferred variable annuity with guaranteed living benefits may be required to put their assets in any of several asset allocation subaccounts Assumed interest rate (AIR): The hypothetical growth rate used to calculate the first payment from a variable income annuity Subsequent payments are larger than the first payment if the underlying assets grow at a rate higher than the AIR, and smaller than the first payment if the underlying assets grow at a rate lower than the AIR Beneficiary: The person designated by the contact owner to receive any payments that may be due if the contract owner or the annuitant dies B-Share variable annuity: Variable annuity contracts that have surrender periods and charges for excess withdrawals during the surrender period The charges typically range from percent to percent in the first year and decline to zero after five to seven years B-Share contracts are the most common form of annuity contracts sold Cash surrender value: The amount that can be withdrawn from the contract after any surrender charge is subtracted from the accumulated value Also called the cash value Charitable gift annuity: An annuity where an individual transfers cash, securities, or property to a charitable organization and the individual (or two people) receives a regular income from the organization for life Contract date, contract year: The date an annuity contract becomes effective Each contract year begins and ends on an anniversary of the contract date Contingent deferred sales charge (CDSC): Also called back-end loads, these fees are charged when an annuity is liquidated during the surrender period Back-end loads typically start at percent to percent of the contract value and decline by percent per year until they disappear Contract owner: The person who pays the premium for the contract The owner can make withdrawals, make investment decisions, surrender the contract, change the beneficiary, and convert a deferred contract to an income stream C-Share variable annuity: Contracts with no up-front or contingent deferred sales charges Also known as no-surrender-charge annuities, they not penalize any withdrawals Death benefit: The payment made to the beneficiary if the contract owner or annuitant dies during the accumulation period The death benefit may be greater than the contract value, depending on the death benefit option chosen by the contract owner Deferred annuity: An annuity contract purchased to help save for retirement The contract can be paid for with a single premium, multiple premiums, or regular contributions The contract owner determines if or when to convert the accumulated value to a regular retirement income Defined benefit plan: An employer-sponsored pension plan that qualifies for special tax treatment under the Internal Revenue Code A retiree covered by the plan receives lifetime payments based on salary, years of service, and age at retirement The employer bears all investment risk Defined contribution plan: An employer-sponsored pension plan in which the employee channels part of his or her income into the plan Contributions are tax deductible up to $15,500 The employer may match a percentage of the employee’s annual contribution, but the employee bears all investment risk Dollar cost averaging: A program for investing a fixed amount of money in mutual funds at set intervals so that more shares are purchased when prices are low and fewer shares are purchased when prices are high Variable annuity contract owners can practice dollar cost averaging by arranging for regular, automatic transfers from a money market subaccount to other subaccounts Exclusion ratio: The formula that determines what percentage of an annuity income payment is taxable and which represents the tax-free return of the original investment, or principal Fixed annuitization: A stream of identical, guaranteed income payments from an annuity contract in the payout stage Fixed annuity: A deferred annuity that guarantees that the contract owner will receive a stated rate of interest through the accumulation phase Fixed income annuity: An income annuity that makes identical payments for the life of one person, two people, or a specific period Flexible premium contract: A contract to which the owner can make additional payments at any time after the initial purchase payment Free-look period: The number of days after the issue of a new contract during which the owner can cancel it General account: All the assets of the insurance company not allocated to the separate accounts When a fixed annuity is purchased, the premium goes into the general account Guarantee period: The period during which the level of interest credited to a fixed annuity is guaranteed not to change Guaranteed lifetime withdrawal benefit (GLWB): A variable annuity rider or option promising that the contract owner can withdraw a certain percentage (4 percent to percent, depending on when payments begin) of a guaranteed benefit base every year for life, regardless of the actual account balance Guaranteed minimum accumulation benefit (GMAB): A promise that the contract value of a variable annuity will be equal to at least a certain minimum amount after a specified number of years Guaranteed minimum death benefit (GMDB): The basic death benefit offered in variable annuity contracts It specifies that if the owner, or in some contracts the annuitant, dies during the accumulation period, the beneficiary will receive either the current contract value or the sum of the purchase payments, minus withdrawals Guaranteed minimum income benefit (GMIB): A guarantee that the owner may receive a guaranteed income stream whose payments are based on the highest of three amounts: the actual contract value, the original premium credited with a specific growth rate, or the highest value of the account on any previous contract anniversary Guaranteed minimum living benefit (GMLB): A benefit that protects the contract owner against investment risks by guaranteeing that the account value or the income payments will be no lower than a specific minimum GMLBs include GMIBs, GMABs, and GMWBs Guaranteed minimum withdrawal benefit (GMWB): A benefit that a certain percentage (usually percent to percent) of a guaranteed benefit base (often the sum of the premiums) can be withdrawn annually until the base is completely paid out, regardless of market performance or the actual account value Immediate annuity: An annuity contract, purchased with a single premium, which begins paying an income within less than 13 months after purchase The payments can be variable or fixed Also call a SPIA, or single premium immediate annuity Income annuity: An immediate annuity Income floor guarantee: A promise that annuity payments will never be less than a specified percentage (such as 80 percent) of the first payment Income options, payout options: The different ways that a contract owner can receive income from an annuity These include lump sum withdrawals, systematic withdrawals, and guaranteed lifetime income Indexed annuity: An annuity whose gains are indirectly linked (through options) to the performance of a broad market index, such as the S&P 500, but that also puts a limit on losses due to poor market performance Insurance charges: The mortality and risk expense charges plus administrative fees Investment management fee: The fee paid to the professional fund managers who manage the money in variable annuity subaccounts Issuer: The insurance company that issues the annuity Joint and survivor annuity: A life annuity in which there are two annuitants, usually spouses In the annuity payout period, the contract makes payments as long as either of the joint annuitants is living Level annuity payments: Annuity payments under a variable annuity contract that change only at the end of a specified period, such as 12 months, when they reset to reflect the actual performance of the investments during the period Life annuity: Annuity payments that are guaranteed to continue for the life of the annuitant Longevity risk: The risk of outliving one’s assets L-Share variable annuities: Variable annuity contracts that typically have shorter surrender periods, such as three or four years, but may have higher M&E charges than other contracts Lump sum option: The option to withdraw all the assets in the annuity in a single payment Market risk: The risk that an investment in stocks or bonds might lose value Also called financial market risk Market value adjustment: A feature of some fixed annuities that adjusts the value of a withdrawal to reflect the impact of a change in interest rates since the contract was purchased If rates have gone up, the value of the contract is adjusted downward If rates have gone down, the value is adjusted upward Minimum credited interest rate: The minimum rate of interest that the owner of a fixed annuity is guaranteed to receive Monte Carlo simulation: A computerized analytical model that considers thousands of possible market scenarios, using hypothetical inflation rates, interest rates, and market returns It then presents the range of probabilities that various scenarios might occur Monte Carlo simulations are an alternative to historical performance for estimating the probability of future market performance Mortality & expense risk charge (M&E): A fee that pays for the insurance guarantees under the contract, such as the death benefit and the right to convert the assets into a lifetime income at rates set in the contract at the time of purchase Nonqualified annuity: An annuity that is not purchased as part of a retirement plan that receives special tax treatment, such as a 401(k) plan or an IRA Partial withdrawal: The withdrawal of an amount less than the entire cash surrender value of the contract Many contracts permit annual withdrawals of a certain amount (such as 10 percent) without a surrender charge Payout phase, payout period: The period during which the money accumulated in a deferred annuity contract, or the purchase payment for an immediate annuity, is paid out as income payments Period certain: The number of years, usually up to 20 years, that income annuity payments are guaranteed to last If the owner dies before the end of the period certain, the beneficiary receives payments for the rest of the period Portfolio rebalancing: A type of asset allocation that periodically restores the relative proportion of the investments in a variable annuity to the contract owner’s desired blend Market performance can, over time, change the balance among investments and therefore change the portfolio’s risk level Premiums or purchase payments: The amounts of money paid into an annuity contract Pure life annuity or straight life annuity: An income annuity whose payments stop when the annuitant dies Qualified annuity: An annuity purchased with pre-tax dollars as part of a retirement program, such as a 401(k) plan, that receives special tax treatment Refund annuity: A type of annuity that guarantees that if the annuitant dies before a specific amount of premiums paid for the annuity are received as income, some or all the premiums will be refunded to the beneficiary Risk pooling: In income annuities, the spreading of longevity risk among a large group of individuals, some of whom will die sooner than expected and some of whom will live longer than expected Section 1035 exchange: The tax-free exchange of one annuity contract for another This exchange must meet certain conditions specified under Section 1035 of the Internal Revenue Code Separate account: An account, consisting of mutual fund-like subaccounts, that receives the money you invest in a variable annuity The separate account is set apart from the insurer’s general account and is legally insulated from the insurer’s general creditors Single premium annuity: An annuity contract that is purchased with a single payment All immediate annuities and some deferred nonqualified annuities are in this category Stepped-up death benefit: A death benefit that is increased regularly to lock in the account value’s investment gains Subaccount: The investment funds offered in variable annuity contracts They may be identical to existing mutual funds, but are subject to different expenses and tax treatments They are held in the insurer’s separate account Surrender charge: The cost to a contract owner for withdrawals from a deferred annuity contract before the end of the surrender period Systematic withdrawal plan: A plan that allows owners of deferred variable annuity contracts to schedule regular withdrawals from the contract instead of converting the assets to a guaranteed income stream Tax-qualified retirement plan: A retirement plan such as an IRA, 401(k), or 403(b) Contributions to such plans qualify for special tax treatment under federal law Transfer: The movement of assets from one subaccount to another Transfer fee: The charge for transfers Most issuers allow a certain amount of free transfers, and impose fees only on excessive transfers Unbundled contracts: Annuity contracts that permit purchasers to choose and pay for the optional features they want, such as a specific guaranteed minimum living benefit Variable annuitization: A stream of income payments that vary based on the investment performance of the underlying subaccounts Variable annuity: An annuity whose contract value or income payments vary based on the investment performance of the underlying subaccounts Variable investment options: The investment choices available to a variable annuity contract owner These choices typically include stock, bond, and money market funds Withdrawal fee: An administrative fee charged on withdrawals Withdrawals: Any distributions from an annuity other than scheduled annuity payments Further Reading ... Wiley, the Wiley Publishing logo, For Dummies, the Dummies Man logo, A Reference for the Rest of Us!, The Dummies Way, Dummies Daily, The Fun and Easy Way, Dummies. com and related trade dress... income Annuities For Dummies, in contrast, is written and designed for the average person, and it focuses a lot of attention on the income-generating aspect of annuities Like all the For Dummies. . .Annuities For Dummies by Kerry Pechter Annuities For Dummies Published by Wiley Publishing, Inc 111 River St Hoboken, NJ