Life Insurance, Disability Income & Annuities · About the Author… Brett W. Decker, CLU Following...
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Life Insurance, Disability Income & Annuities Copyright 2017: Brett Decker, CLU All rights reserved. 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 or otherwise, without the prior written permission of the Author. Although great effort has been made to ensure this publication contains accurate and timely information, it is provided with the understanding that the author and provider is not engaged in rendering legal, accounting, tax, or other professional service. If professional advice is required, the services of a competent advisor should be sought. Created in the United States of America By: Brett Decker, CLU 1.770.509.8373 www.BrettDecker.com
Transcript of Life Insurance, Disability Income & Annuities · About the Author… Brett W. Decker, CLU Following...
Life Insurance,
Disability Income & Annuities
Copyright 2017: Brett Decker, CLU All rights reserved. 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 or otherwise, without the prior written permission of the Author. Although great effort has been made to ensure this publication contains accurate and timely information, it is provided with the understanding that the author and provider is not engaged in rendering legal, accounting, tax, or other professional service. If professional advice is required, the services of a competent advisor should be sought.
Created in the United States of America
By: Brett Decker, CLU 1.770.509.8373
www.BrettDecker.com
About the Author…
Brett W. Decker, CLU
Following a successful 25+ year financial planning and sales career at various levels within the financial services and insurance industries, Brett W. Decker, CLU, has also established a highly successful track record as an Insurance CE subject matter expert and a CE provider resource over his most recent 16+ years. Brett has forged a new path by providing CE courses, resources, and services to CE providers and students all around the USA. He is a highly regarded "contract" instructor for Insurance CE Classes and Webinars and has conducted planning and insurance related live events for over 15 years with high marks from well over 10,000+ satisfied students in dozens of subject areas. In that same period, he also created and authored more than 80 specialized insurance CE courses, as well as updated and revised dozens more for CE providers nationally. With 30+years of experience in insurance sales, training, and client building activities in the insurance and financial services industries, he is also a recognized broad based subject matter specialist. Brett's broad-based background, practical experience, "hands on" work in the insurance business, and exposure to the foremost marketing, sales and training consultants nationally uniquely equips him for the 'partner' role that he sees for himself in the education and support of others. His work with experts in the fields of communication, training and business development has given him much to draw on for his CE clients’ and students’ benefit. His interviews, conversations, and relationships with countless insurance people nationally add to his insight in CE course creation for the financial planning and insurance industries.
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Table of Contents
Course Overview and Objectives ................................................................................................. iUnit ONE ....................................................................................................................................... 1Life Insurance................................................................................................................................ 1Section 1 - Overview and Objectives ........................................................................................... 2Chapter 1 ....................................................................................................................................... 3Life Insurance................................................................................................................................ 3
The Basics ................................................................................................................................... 3Defining Life and Health Insurance ........................................................................................ 4Principles and Concepts .......................................................................................................... 5The Uses of Life Insurance ..................................................................................................... 5
How Much Life Insurance is Needed? ........................................................................................ 6Human Life Value (HLV) ....................................................................................................... 6Need Analysis ......................................................................................................................... 6Gathering of Information ........................................................................................................ 6Establishing Objectives ........................................................................................................... 6Analyzing Information ............................................................................................................ 6Developing a Plan ................................................................................................................... 7Implementing the Plan ............................................................................................................ 7Monitoring and Reviewing the Plan Periodically ................................................................... 7Single Need Approach to Life Insurance ................................................................................ 7
Estate Settlement Needs ...................................................................................................... 7Readjustment Period ........................................................................................................... 7Dependency Period ............................................................................................................. 7Blackout Period ................................................................................................................... 7Special Needs ...................................................................................................................... 7Retirement Fund .................................................................................................................. 8
Insurable Interest ......................................................................................................................... 8Insurable Interest in One's Own Life ...................................................................................... 8Insurable Interest in Another Person's Life ............................................................................. 8
Family and Marriage Relationships .................................................................................... 8Creditor-Debtor Relationships ............................................................................................ 8Business Relationships ....................................................................................................... 8
Chapter 2 ..................................................................................................................................... 10Types of Life Insurance Products .............................................................................................. 10
Basic Life Insurance ................................................................................................................. 10Term Insurance ..................................................................................................................... 10Permanent or Whole Life ...................................................................................................... 10Classifications ....................................................................................................................... 11
Term Insurance ......................................................................................................................... 11Understanding Term Insurance ............................................................................................. 11Renewable Term ................................................................................................................... 12Convertibility ........................................................................................................................ 12Level Term ............................................................................................................................ 12Decreasing Term Insurance .................................................................................................. 14
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Reentry Term ........................................................................................................................ 14Credit Life Insurance – Individual ........................................................................................ 14
Individual policies ............................................................................................................. 15Joint policies ..................................................................................................................... 15Group policies ................................................................................................................... 15
Whole Life Insurance ................................................................................................................ 15Understanding Whole Life Insurance ................................................................................... 15Term Life - Risk .................................................................................................................... 16
Permanent Life Premiums and Cash Value Features ................................................................ 16Cash Value Features ............................................................................................................. 17Whole Life ............................................................................................................................ 17Whole Life - Risks ................................................................................................................ 17Whole Life Cash Values ....................................................................................................... 17Straight and Modified Life .................................................................................................... 17Modified Life ........................................................................................................................ 18Graded Premium Whole Life ................................................................................................ 18Limited Pay Life ................................................................................................................... 1830 Pay Life, 20 Pay Life, 15 Pay Life or 10 Pay Life ........................................................... 18Life Paid Up at 65 ................................................................................................................. 19Single Pay Life ...................................................................................................................... 19Industrial Life Insurance ....................................................................................................... 19
Combination Policies ................................................................................................................ 19Developing Policies .............................................................................................................. 19Whole Life PLUS Term Policy ............................................................................................. 20
Family Policy .................................................................................................................... 20Family Income .................................................................................................................. 20Family Maintenance .......................................................................................................... 20
Versions of Whole Life ............................................................................................................. 21Varieties of Whole Life ........................................................................................................ 21
Joint Life ........................................................................................................................... 21Joint Life (first-to-die) ...................................................................................................... 21Joint Life and Survivorship (second-to-die) ..................................................................... 21Extra Ordinary Life ........................................................................................................... 21Indexed Whole Life .......................................................................................................... 21Graded Premium Whole Life ............................................................................................ 22Last Survivor Life ............................................................................................................. 22Juvenile Insurance ............................................................................................................. 22Retirement Income ............................................................................................................ 22Indeterminate Premium Policies ....................................................................................... 23Endowment Insurance ....................................................................................................... 23Flexible Premium & Interest-Sensitive Life Products ...................................................... 23Conservative Industry ....................................................................................................... 24Interest Rates ..................................................................................................................... 24
Adjustable Life ...................................................................................................................... 25Universal Life ....................................................................................................................... 25
Mortality Charges ............................................................................................................. 26
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Policy Flexibility ............................................................................................................... 26Accumulating Cash Value ................................................................................................ 27
Variable Life Insurance ......................................................................................................... 27Variable Life's Purpose ..................................................................................................... 28Variable Life Cash Values ................................................................................................ 28Regulation of Variable Life .............................................................................................. 28
Variable Universal Life ......................................................................................................... 29Indexed Universal Life ......................................................................................................... 29
Policy Provisions of Life Insurance Policies ............................................................................ 30Overview ............................................................................................................................... 30Ownership Clause ................................................................................................................. 30Entire Contract Clause .......................................................................................................... 30Incontestable Clause ............................................................................................................. 30Suicide Clause ....................................................................................................................... 31Grace Period .......................................................................................................................... 31Reinstatement Clause ............................................................................................................ 31Misstatement of Age ............................................................................................................. 31Beneficiary Designation ........................................................................................................ 32Change of Plan Provision ...................................................................................................... 32
Life Insurance Policy Riders ..................................................................................................... 32Waiver of Premium ............................................................................................................... 33Accidental Death and Dismemberment ................................................................................ 33Guaranteed Purchase Option ................................................................................................. 33Accelerated Death Benefit .................................................................................................... 34Renewal Provision/Guaranteed Insurability Rider ............................................................... 34Family Income Benefit Rider ................................................................................................ 34Long-Term Care Riders ........................................................................................................ 34
Nonforfeiture Options ............................................................................................................... 35Cash Surrender Value ........................................................................................................... 35Reduced Paid-Up Insurance .................................................................................................. 36Extended Term Insurance ..................................................................................................... 36Automatic Premium Provision .............................................................................................. 36Dividend Accumulations to Avoid Lapse ............................................................................. 36
Dividend Options ...................................................................................................................... 37Cash Payment ........................................................................................................................ 37Reduction of Premium .......................................................................................................... 37Accumulation of Interest ....................................................................................................... 37Paid-Up Additions ................................................................................................................ 37One-Year Term ..................................................................................................................... 37
Settlement Options .................................................................................................................... 38Lump Sum Settlement ........................................................................................................... 38Proceeds and Interest ............................................................................................................ 38Fixed Years Installments ....................................................................................................... 38Life Income ........................................................................................................................... 38
Example: ........................................................................................................................... 39Joint Life Income .................................................................................................................. 39
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Fixed Amount Installments ................................................................................................... 39Other Mutually Agreed Method ............................................................................................ 39
Premiums .................................................................................................................................. 40Single and Periodic Premiums .............................................................................................. 40Parts of the Premium ............................................................................................................. 40Net and Gross Premium ........................................................................................................ 41Mortality and Interest Factors ............................................................................................... 41Level Premium Concept Reserves ........................................................................................ 41Insurance Age ....................................................................................................................... 42
Tax Treatment of Life Insurance .............................................................................................. 43The Role of Insurance Programs ........................................................................................... 43Favorable Tax Treatment ...................................................................................................... 43
Tax Treatment of Premiums ............................................................................................. 43Tax Treatment of Cash Value Accumulation ................................................................... 43Tax Treatment of Death Benefits - Proceeds of Life Insurance - Not Taxable ................ 44Tax Consequences of a Policy Surrender ......................................................................... 44Tax Treatment of Policy Loans ......................................................................................... 44Premiums that are not deductible ...................................................................................... 44Personal Life Insurance ..................................................................................................... 44Life Insurance and Estate Taxes ....................................................................................... 45Third-Party Ownership of Life Insurance ......................................................................... 45Transfer of Value Rule ...................................................................................................... 45Modified Endowment Contract (MEC) ............................................................................ 457 Years .............................................................................................................................. 45Forever .............................................................................................................................. 45No Penalty to Beneficiary ................................................................................................. 45
Chapter 3 ..................................................................................................................................... 46Life Insurance Needs and Uses .................................................................................................. 46
Insurance Needs ........................................................................................................................ 46Identifying Life Insurance Needs .......................................................................................... 46
Insurance Needs ................................................................................................................ 46Human Life Value ............................................................................................................. 46Financial Needs Approach ................................................................................................ 47
Uses of Life Insurance .............................................................................................................. 48Personal Uses ........................................................................................................................ 48Charitable Uses ..................................................................................................................... 48Business Uses ....................................................................................................................... 48
Buy-Sell Agreements ........................................................................................................ 48The Entity Purchase Buy-Sell Agreement ........................................................................ 49The Cross Purchase Buy-Sell Agreement ......................................................................... 49Key-Employee Life ........................................................................................................... 49Section 303 Redemption ................................................................................................... 50
Unit TWO .................................................................................................................................... 51Disability Income ........................................................................................................................ 51
Course Description Course Overview and Objectives .............................................................. 52Chapter 1 ..................................................................................................................................... 53
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Disability Income ........................................................................................................................ 53Disability Income Fundamentals .............................................................................................. 53
Introduction ........................................................................................................................... 53Disability Income Insurance Can Help ................................................................................. 53
Disability Is Likely to Prevent Us From Working ............................................................ 54What Disability Means Financially for Us and Our Family ............................................. 54Disability Income Insurance ............................................................................................. 54
Government-sponsored programs ................................................................................. 54Private employer-sponsored group disability plans ...................................................... 54Private individual disability income policies ................................................................ 54
When You are Covered by Group Disability Benefits ..................................................... 55Short-term ..................................................................................................................... 55Long-term ..................................................................................................................... 55
Would You Qualify for Social Security Disability Insurance (SSDI) Benefits? .............. 55Social Security Disability Insurance ............................................................................. 55Know what to expect: ................................................................................................... 56Be aware of what some people get ............................................................................... 56
What Does Workers' Compensation Cover? .................................................................... 56Disability Income From Other Sources? ........................................................................... 57How Much Disability Income Will You Need? ............................................................... 57What to Look for in a Policy ............................................................................................. 58
Definition of Disability ................................................................................................. 58Extent of Disability (Total or Partial) ........................................................................... 58Residual Benefits .......................................................................................................... 59Presumptive Disability .................................................................................................. 59Amount of Benefits ....................................................................................................... 59When Payments Begin .................................................................................................. 59
What the Policy Does and Does Not Cover ...................................................................... 60What to Expect When Applying for Coverage ..................................................................... 61
What Else Do You Need to Know? .................................................................................. 61Tax Considerations ....................................................................................................... 61Business Protection for Small Business Owners .......................................................... 61
Disability Insurance Policy Checklist ................................................................................... 62Final Note .............................................................................................................................. 62
Chapter 2 ..................................................................................................................................... 64Group Long-Term and Short-Term Disability Income .......................................................... 64
Three Principal Contingencies .................................................................................................. 64Death, Retirement, and Disability ......................................................................................... 64
The Purpose of Disability Income Insurance ............................................................................ 65Short Term Disability ............................................................................................................... 66
Definition of Disability ......................................................................................................... 66Amount of Benefits ............................................................................................................... 67Elimination Periods ............................................................................................................... 67Probationary Periods ............................................................................................................. 67Plan Financing ...................................................................................................................... 68Benefit Amounts ................................................................................................................... 68
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Weekly Income ................................................................................................................. 68Benefit Duration .................................................................................................................... 68
Benefit Payment Periods ................................................................................................... 68Continual Periods of Disability ............................................................................................. 69
Continuous Disability ....................................................................................................... 69Exclusions ............................................................................................................................. 69Termination of Coverage ...................................................................................................... 69
Cancelable Contracts ........................................................................................................ 69Long-Term Disability Income .................................................................................................. 70
Long-Term Disability ........................................................................................................... 70Definition of Disability ......................................................................................................... 70Individual and Group Long-Term Disability Income Coverage ........................................... 71
Long-Term Disability ....................................................................................................... 71Benefit Amounts ............................................................................................................... 71Duration of Benefits .......................................................................................................... 72Elimination Period ............................................................................................................ 72Probationary Periods ......................................................................................................... 72Continuous Periods of Disability ...................................................................................... 72
Other Provisions.................................................................................................................... 73Survivors' Benefits ............................................................................................................ 73Rehab ................................................................................................................................ 73Pension Supplement .......................................................................................................... 73
Return of Premium Rider (RPR) ........................................................................................... 73Cash Surrender Value Feature .............................................................................................. 74Plan Financing ...................................................................................................................... 75Exclusions ............................................................................................................................. 75Disability Income in Pension Plans ...................................................................................... 76LTD vs. Individual Disability Income Policies .................................................................... 76
Basic Differences .............................................................................................................. 76Taxation Information ............................................................................................................ 77
Taxes ................................................................................................................................. 77Chapter 3 ..................................................................................................................................... 78Salary Continuation and Association Disability Income Plans .............................................. 78
Environment an Marketplace .................................................................................................... 78Salary Continuation Plan ...................................................................................................... 79Association Plan .................................................................................................................... 79Salary Continuation Plans ..................................................................................................... 79
"Sick Pay" Plans ............................................................................................................... 79FICA ..................................................................................................................................... 80Employee Benefits ................................................................................................................ 80
Salary Continuation Plans ................................................................................................. 80Funding ................................................................................................................................. 81
Self-Funding ..................................................................................................................... 81Methods of Payment ............................................................................................................. 82
Employee Pay System ....................................................................................................... 82Employee-Pay-All ................................................................................................................. 82
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Splitting the Premium ........................................................................................................... 82Executive Bonus Plan ........................................................................................................... 83Association Disability Income Plans .................................................................................... 83
Individual Disability Income Products ............................................................................. 83Membership Benefits ............................................................................................................ 84
Coverage ........................................................................................................................... 84Chapter 4 ..................................................................................................................................... 86Disability Buy-Sell Agreements ................................................................................................. 86
Identifying Disability Risk Exposures ...................................................................................... 86Options .................................................................................................................................. 86The Importance of the Buy-Sell Agreement ......................................................................... 87
Health Risk Exposure ....................................................................................................... 87Business Overhead Expense Policy .......................................................................................... 88
BOE Policy ........................................................................................................................... 88Salary Continuation Plan ...................................................................................................... 88
Characteristics ................................................................................................................... 88Disability Buy-Out Plan ........................................................................................................ 89
Description ........................................................................................................................ 89Timeline ................................................................................................................................ 90Types of Disability Buy-Out Plans ....................................................................................... 91
Entity Purchase or Cross-Purchase Plan ........................................................................... 91Method of Arriving at the Purchase Price ............................................................................. 92
Specific Price Method ....................................................................................................... 92Fixed Price Method ........................................................................................................... 92
Valuation Formula ................................................................................................................ 92Remission and Returns to Work ........................................................................................... 92Provisions .............................................................................................................................. 93Probability of Long-Term Disability .................................................................................... 94
Tables ................................................................................................................................ 94Sample Agreement ................................................................................................................ 97
Articles .............................................................................................................................. 97Chapter 5 ................................................................................................................................... 101Business Overhead Expense Insurance ................................................................................... 101
When the Professional Person Becomes Disabled .................................................................. 101Business Overhead Expense Insurance ............................................................................... 101Evolution ............................................................................................................................. 101
History............................................................................................................................. 101Insured Markets .................................................................................................................. 102
Disability ......................................................................................................................... 103Reimbursement of Expenses ............................................................................................... 104Premium Costs .................................................................................................................... 104Benefit Limitations and Exclusions .................................................................................... 104Benefit Duration .................................................................................................................. 105Comparison with Individual Policies .................................................................................. 105Tax Aspects ......................................................................................................................... 105Summing It Up .................................................................................................................... 106
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Unit THREE .............................................................................................................................. 107Annuities .................................................................................................................................... 107
Course Description Course Overview and Objectives ............................................................ 108Chapter 1 ................................................................................................................................... 109Annuities Basics ........................................................................................................................ 109
Annuity Overview ................................................................................................................... 109Introduction ......................................................................................................................... 109Background ......................................................................................................................... 110What is an Annuity? ............................................................................................................ 110Qualified or Non-qualified .................................................................................................. 111
Qualified ......................................................................................................................... 111Non-qualified .................................................................................................................. 111
Immediate or Deferred ........................................................................................................ 112Immediate ....................................................................................................................... 112Deferred Annuity ............................................................................................................ 112
Fixed or Variable ................................................................................................................ 112Fixed ............................................................................................................................... 112Variable ........................................................................................................................... 112
Phases of an Annuity .......................................................................................................... 112Contribution .................................................................................................................... 113Accumulation .................................................................................................................. 113Distribution/Annuitization .............................................................................................. 113
Interest rates – Guaranteed and Current .............................................................................. 113Premiums - Single or Flexible ............................................................................................ 113Maximum Ages for Issue and Benefits ............................................................................... 113
Settlement Options .................................................................................................................. 114Period Certain Only ........................................................................................................ 114Life Only ......................................................................................................................... 114Life and Period Certain ................................................................................................... 114Life Only with Guaranteed Minimum Option ................................................................ 114Joint and Survivor ........................................................................................................... 114
Surrender / Penalty Charges ................................................................................................ 115Death and Disability ....................................................................................................... 115Nursing Home Waiver .................................................................................................... 115
Withdrawals ........................................................................................................................ 116Loans ................................................................................................................................... 116Bail Out ............................................................................................................................... 116
Types of Annuities .................................................................................................................. 117Fixed Annuities ................................................................................................................... 117Bonus Annuities .................................................................................................................. 117CD Type Annuities ............................................................................................................. 117Bond Index Annuities ......................................................................................................... 117Equity Index Annuities ....................................................................................................... 118Tax Sheltered Annuities ...................................................................................................... 118Variable Annuities .............................................................................................................. 118
Chapter 2 ................................................................................................................................... 119
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Fixed Annuities & Variations .................................................................................................. 119Fixed Annuities ....................................................................................................................... 119
What is a Fixed Annuity? ................................................................................................... 119Tax-Deferred ....................................................................................................................... 119Tax-deferral Advantages ..................................................................................................... 119The Tax-Deferred Advantage ............................................................................................. 120
Tax-Deferred vs. Fully Taxable ...................................................................................... 120Safety .................................................................................................................................. 121No More 1099’s .................................................................................................................. 121When Does Annuity Money Mature? ................................................................................. 121What is the Penalty Tax and When Does it Apply? ............................................................ 121Avoids Probate? .................................................................................................................. 121
Single Premium Annuities ...................................................................................................... 121What is a Single Premium Annuity .................................................................................... 121Tax-Favored Income ........................................................................................................... 122No Investment Risk ............................................................................................................. 122Income Options ................................................................................................................... 122
Period Certain Only ........................................................................................................ 122Life Only ......................................................................................................................... 122Life and Period Certain ................................................................................................... 123Life Only with Guaranteed Minimum Option ................................................................ 123Joint and Survivor ........................................................................................................... 123
CD Type Annuities ................................................................................................................. 123Bonus Annuities .................................................................................................................. 123
Interest Rates ................................................................................................................... 123Characteristics ..................................................................................................................... 123Surrender Charges ............................................................................................................... 124Withdrawal Charges ............................................................................................................ 124
Equity Index Annuities ........................................................................................................... 124How are They Different from Other Fixed Annuities? ....................................................... 125What Are Some of the Contract Features? ......................................................................... 125
Indexing Method ............................................................................................................. 125Specific Term .................................................................................................................. 126Policy Year ...................................................................................................................... 126Percentage Change .......................................................................................................... 126Ratchet Method or Annual Reset .................................................................................... 126Spread Method ................................................................................................................ 126High Water Mark ............................................................................................................ 126Low Water Mark ............................................................................................................. 127Interest Rate Crediting .................................................................................................... 127Adding Interest ................................................................................................................ 127Margin-Spread-Administrative Fee ................................................................................ 127Vesting ............................................................................................................................ 127Participation Rate ............................................................................................................ 127Cap Rate or Cap on Interest Earned ................................................................................ 128Floor on Equity Index-Linked Interest ........................................................................... 128
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Averaging ........................................................................................................................ 128How Do The Common Indexing Methods Differ ............................................................... 129
Annual Reset ................................................................................................................... 129Advantage ................................................................................................................... 129Disadvantage ............................................................................................................... 129
High-Water Mark ............................................................................................................ 129Advantage ................................................................................................................... 129Disadvantage ............................................................................................................... 129
Point-to-Point .................................................................................................................. 130Advantage ................................................................................................................... 130Disadvantage ............................................................................................................... 130
How Do I Know Which Equity-Indexed Annuity is Best For Me? .................................... 130What is the S&P 500 Composite Stock Price Index? ......................................................... 130
Standard & Poor’s 500 .................................................................................................... 130History............................................................................................................................. 130Distribution of the S&P 500 Index ................................................................................. 131S&P Index Committee .................................................................................................... 131
Comparison to the Dow Jones Industrial Average ............................................................. 131The S&P 500 Index ............................................................................................................. 131Standard & Poor's 500 Index History ................................................................................. 132
Bond Index Annuities ............................................................................................................. 132Fixed Account ................................................................................................................. 133CD Type Account ........................................................................................................... 133Equity Index Accounts .................................................................................................... 133Convertible Bond Account ............................................................................................. 133Investment Grade Account ............................................................................................. 133High Yield Bond Account .............................................................................................. 133
Market Value Adjusted Annuities .......................................................................................... 133How the MVA Works ......................................................................................................... 133How the MVA is Different ................................................................................................. 134
Risk Factor ...................................................................................................................... 134Chapter 3 ................................................................................................................................... 135Variable Annuities .................................................................................................................... 135
Unique Investment Product ..................................................................................................... 135Family of Funds .................................................................................................................. 135Loading and Management Fees .......................................................................................... 135Advantages of Variable Annuities ...................................................................................... 136Tax Treatment of Variable Annuities ................................................................................. 136Required Distributions… .................................................................................................... 136Taxation of Variable Annuities ........................................................................................... 137Withdrawals ........................................................................................................................ 137Penalty Tax on Premature Distributions ............................................................................. 137Taxation of Death Benefit Proceeds ................................................................................... 138Accumulation Period .......................................................................................................... 138Fixed Account ..................................................................................................................... 138Separate Account ................................................................................................................ 139
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Chapter 4 ................................................................................................................................... 140Specialized Annuities ................................................................................................................ 140
Tax Sheltered Annuities (TSAs) ............................................................................................. 140Three Benefits ..................................................................................................................... 140Can their Employer Make Contributions for them? ........................................................... 141How can contributions be made? ........................................................................................ 141
Elective Deferrals ............................................................................................................ 141Non-elective contributions .............................................................................................. 141After-tax contributions .................................................................................................... 141Combination .................................................................................................................... 141
How Much Can Be Contributed? ........................................................................................ 141When can a TSA be Set Up? ............................................................................................... 142What can TSA Funds be Invested In? ................................................................................. 142Who Is the Custodian of the Assets? .................................................................................. 142When Is a Distribution Required? ....................................................................................... 142What Is the Penalty for Early Withdrawals? ....................................................................... 142Can TSA Funds Be Borrowed? ........................................................................................... 142What Happens at the Death of a TSA Participant? ............................................................. 142How Does a Participant Change From One TSA to Another? ........................................... 143Can Deferred Amounts Be Counted as Current Compensation? ........................................ 143
Impaired Risk Annuities ......................................................................................................... 143Immediate Annuities - Is Bad Health Good? ...................................................................... 143
Chapter 5 ................................................................................................................................... 145Taxation, Distribution & Exchanges ....................................................................................... 145
Taxation & Distribution .......................................................................................................... 145Avoid Probate ..................................................................................................................... 146
Minimum Required Distributions ........................................................................................... 146Retirement Plans Covered ................................................................................................... 146Multiple Retirement Plans .................................................................................................. 146IRA Penalty ......................................................................................................................... 147Calculating the MRD .......................................................................................................... 147Distributions Prior to Age 59½ ........................................................................................... 147Exceptions to the Premature Distribution Penalty Tax ....................................................... 147
Unreimbursed Medical Expenses ................................................................................... 147Medical Insurance ........................................................................................................... 148Disability ......................................................................................................................... 148Death ............................................................................................................................... 148Higher Education Expenses ............................................................................................ 148Eligible Educational Institution ...................................................................................... 149First Home ...................................................................................................................... 149
Qualified Acquisition Costs ........................................................................................ 150First-Time Homebuyer ................................................................................................ 150Date of Acquisition ..................................................................................................... 150
Avoidance of the Pre 59½ Distribution Penalty ................................................................. 150An Annuity Payout Option ................................................................................................. 150State Premium Taxes on Variable Annuities ...................................................................... 151
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1035 Exchanges ...................................................................................................................... 152Life Insurance to Annuity ................................................................................................... 152Annuity to Annuity ............................................................................................................. 152Partial 1035 Exchange ........................................................................................................ 152“One for Two” 1035 ........................................................................................................... 153
Chapter 6 ................................................................................................................................... 154Special Usage ............................................................................................................................. 154
Charitable Gift Annuities ........................................................................................................ 154How Do Charitable Gifts Work? ........................................................................................ 154The Gift and Tax Deduction ............................................................................................... 155
Cash................................................................................................................................. 155Securities ......................................................................................................................... 155
The Income ......................................................................................................................... 155Guaranteed Income ......................................................................................................... 155Non Taxable Income ....................................................................................................... 155
Examples of a Charitable Gift Annuity .............................................................................. 155A Gift based on a Single Life ......................................................................................... 155
Structured Settlements ............................................................................................................ 156Tax Advantages .................................................................................................................. 157A Negotiated Settlement ..................................................................................................... 157Qualified Assignments ........................................................................................................ 157
Split Annuities ........................................................................................................................ 158Advantages of a Split Annuity ............................................................................................ 158
Dependable Income ........................................................................................................ 158Tax-Advantaged Income ................................................................................................. 158Tax-Deferred Growth and Principal Preservation .......................................................... 158Plan Limitations .............................................................................................................. 158
Example of a Split Annuity ................................................................................................. 159
Life Insurance, Disability Income, & Annuities
Course Overview and Objectives
This course is a comprehensive insurance course that explores and details the different types of products and situations involving life insurance, disability income, and annuities along with their many uses when it comes to providing for individual, family, and business needs. It covers term, permanent, adjustable, universal, and variable life insurance along with the numerous variations within each category. It outlines and teaches the many uses of life insurance, both personal and business. In addition, your course explains the income and estate taxation of life insurance along with an extensive discussion of payout options, policy loans, premiums, withdrawals, dividends, cash surrenders, and accelerated death benefits concepts. The disability income component in this course is designed to review and teach you about the features of the various types of disability insurance options and non-insurance specific programs, as well. The course explores individual disability insurance, employer-provided disability insurance, government programs that pay disability benefits, and the taxes inherent on these benefits. Provided also is a discussion of the specialized disability-related policies that are used for overhead expenses and buy-sell agreements. Association and Salary continuation arrangements with group disability income protection programs are discussed, as well. The annuity section profiles the annuity concept and details as well as explains what an annuity is and how it works. The fundamentals of the accumulation and payout phases of annuities are discussed. Settlement options are explained along with their most common uses being covered. This section also discusses taxation of annuities. Federal income tax treatment of premature withdrawals, lump-sum distributions, and periodic payments are dealt with fully. It covers the different types of annuity contracts and the characteristics of each of the fixed, variable and equity indexed varieties. Annuity product types with their features and benefits are highlighted including specifics such as premium options, immediate vs. deferred, qualified vs. nonqualified, and the whole host of settlement options. We’re confident, whether you are a newer producer or planner, or a veteran producer or planner, that you will gain valuable insight into this critical area for Americans as well as brush up on current info and details pertinent to this area of your expertise.
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Unit ONE Life Insurance
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Section 1 - Overview and Objectives
This section is a comprehensive exploration which details the different types of products and situations involving life insurance, along with its many uses when it comes to providing for individual, family, and business needs. It covers term, permanent, adjustable, universal, and variable life insurance along with the numerous variations within each category. It outlines and teaches the many uses of life insurance, both personal and business. In addition, your course explains the income and estate taxation of life insurance along with an extensive discussion of payout options, policy loans, premiums, withdrawals, dividends, cash surrenders, and accelerated death benefits concepts.
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Chapter 1 Objectives Upon completion of this section, you will:
§ Learn about the basics of life insurance principles, concepts, and uses. § Discover how much life insurance is needed using HLV and a planning tool. § Gain insight into the important aspects regarding insurable interest.
Chapter 1 Life Insurance
The Basics It has been said by many that life insurance is one of the most innovative financial instruments ever devised by mankind and one of the few that no one has ever been able to duplicate. How about this example as the fundamental concept underlying life insurance? Bring together a bunch of people of a lot of different ages that are all bound to die sooner or later (but not all at one time). Have them all chip into the pot some differing number of pennies every year based on their age (younger put in less, older put in more) and health condition (good health pays less, poor health pays more), and how much they want to be paid out of the pot at their death. When any one of them dies, someone other than them (usually their spouse) receives a bunch of dollars. A bunch being a lot more than the total of all the pennies the individual put in prior to their death (even if they die the day after they put their first pennies in the pot). Pretty simple…right? The concept and practical applications of life insurance today are still basically simple and straight-forward. For a premium paid in, dollars are delivered to beneficiaries of those who are insured when they die. Having said this, the whole arena surrounding life insurance and its applications is vast. With its many uses for financial protection for individuals, families, businesses, and charitable giving, the life insurance landscape is far reaching and one of the most important financial tools for financial security and peace of mind for millions of Americans. Income replacement, education assurance, retirement security, business continuation, estate conservation and charitable giving with all the subsets of each of these key financial categories are all advanced through the applications of life insurance in combination with other legal and financial instruments.
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The addition of an enormity of additional features, benefits, and options over the years have all added to the complexity and adaptability of the growing number of variations in the different types of policies and specialized approaches for life insurance solutions. Taxation relative to life insurance itself and taxation in our individual and business situations add an additional measure of complexity to the equation. Changing tax laws further make it important for all of us in the financial services industry to be vigilant in being up to date on how these factor in to how we apply life insurance as a solution to individual, family and business situations. While we will go into more detail on the different types of life insurance and the many applications and uses of it throughout your course, it would be good to start out by taking a brief generic look at the basic categories of life insurance and the variety of product types within each category. Like most things in life, there is no “one size fits all”. This is especially true with life insurance and the many varieties and forms that it has taken over the years. How it is purchased, the basis on which premiums are paid, the method of accumulation of values inside the policy, and other specialized benefits, features, and options all become characteristics of the many variations available to people to best match their philosophy, situation, and pocketbook. The advantage of having a wide variety of product designs to choose from brings along with it the challenge of winnowing and sifting through them to be a competent teacher and advisor to the people we serve in meeting their expectations for sound solutions to their needs and wants.
Defining Life and Health Insurance Let’s start by defining insurance. Insurance is a contract between an insurance company and a person or group which provides for a money payment in case of covered loss, accident or death. It is a promise of reimbursement in the case of loss; paid to people or companies so concerned about hazards that they have made prepayments to an insurance company. You might say that it is someone else's guarantee to cover a loss incurred by you. If you guess any of these you would be right; these are generally speaking what insurance is. Life insurance is a contract between an individual and an insurance company. In this contract, the insurance company agrees to pay a stated amount of money to a beneficiary, under certain conditions, in exchange for a sum of money called the premium. It is important to note that a life insurance policy is in fact a legal contract. It is an agreement between two parties to do something in exchange for the premium that is paid to the company. For some, auto insurance usually comes to mind first when we envision insurance. We know an accident is always possible and, more importantly, most of us know we could not easily afford the potentially high cost of restoring or replacing a lost or damaged auto. Therefore, we let someone else assume the risk of covering the loss. Because we readily accept the possibility that property loss can occur at any time, we purchase insurance to protect it and feel relieved.
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Insurance that covers automobiles, houses, personal possessions and anything else that is tangible is called property insurance. We value our hard-earned possessions, and thus we have no difficulty understanding the need to insure against their loss (although we may never enjoy paying the premiums needed to do so).
Principles and Concepts While people readily see the need to protect their tangible possessions, they sometimes have difficulty seeing the need to protect their intangible possessions, including their lives. When you think of it, though, the economic loss incurred by a serious illness, disability, or death can be far greater than the loss of any piece of property, but many of us overlook this when we consider our insurance needs. The single biggest challenge an insurance salesperson faces will be to make people recognize and face up to the need to protect against the economic loss of their health, life, or ability to earn a living. Insurance is a means of protecting someone (the insured) from the economic loss of something of value. In this course, we will review the types of life insurance products that are available to protect against the risk of economic loss due to dying too soon. Insurance is also defined, less formally, as a socially accepted means of transferring the risk of economic loss to a common pool of funds contributed by many people sharing the same risk. Life insurance is a contractual agreement (insurance policy) on the part of one party (the insurer) to pay a sum of money to a second party (the insured) upon a specified happening (death, disability, illness, or conversion to an annuity) provided a stipulated consideration (the premium) has been properly paid.
The Uses of Life Insurance Life insurance is primarily used to function in personal and family situations. As a rule a person's death creates an immediate need for money. The following is a list of some of the needs that might be created from an individual's death.
§ Expenses created by final illness. § Burial and funeral expenses. § Debts due at time of death. § Costs to administer the estate. § Federal and state death taxes. § Inheritance taxes. § Money may also be needed to provide for the following: § Payoff mortgage or purchase a new home. § Provide an education for children. § Meet unexpected financial needs. § Life insurance can also provide benefits for business situations. Here are a few
examples: § Loss caused by death of a key employee.
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§ Collateral for loans. § A business insurance fund. § Buy-out business interest of a deceased owner. § Fringe benefits for employees. § Fund qualified retirement plans.
How Much Life Insurance is Needed? The unique quality about life insurance is that it creates an immediate estate. Although estates can be developed in a number of other ways, they all require many years to accomplish. Only life insurance creates an estate immediately. There are two ways to evaluate how much life insurance a person needs.
Human Life Value (HLV) If a person is seeking to replace income that would be lost because of a premature death, this is called the Human Life Value approach. The late Solomon S. Huebner of the American College in Bryn Mawr, PA developed this concept. (The American College awards the prestigious Chartered Life Underwriter (CLU) and Chartered Financial Consultant (ChFC) designations.)
Need Analysis If a person is concerned with how much money a beneficiary would need to pay the mortgage, feed, clothe and educate the children, etc., in the event of a provider's premature death, the approach is called Need Analysis. This widely used approach is sometimes called Life Insurance Programming. It is also called the "Total Approach" to assess needs. It is the application of the risk management process to the sale of life insurance. The steps include:
Gathering of Information This includes identifying assets, liabilities, income, savings and investments and "lump-sum" needs for postmortem expenses. Postmortem expenses include the costs of funeral expenses, medical expenses, and probating an estate.
Establishing Objectives A "lump-sum" need for debt cancellation, emergency reserve funds, education funds, retirement funds and bequests. Objectives also include planning for the income needs of the family by replacing the lost salary of the deceased. The "blackout" period of Social Security must be taken into account. (The "blackout" period is the time when a surviving spouse is not receiving Social Security benefits.)
Analyzing Information Post death financial objectives usually fall into two groups: Cash and income. Cash requires a single sum to fulfill. Income objectives require the adoption of either a capital liquidation
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method or a capital retention method. Naturally, a capital liquidation would require a lower amount of life insurance.
Developing a Plan The agent would identify one or more policies that would accomplish the objectives already developed.
Implementing the Plan Taking the application and required first premium.
Monitoring and Reviewing the Plan Periodically Significant changes in a client's life, such as marriage, divorce, buying a home, birth of children, etc. requires making the needed changes in an insurance program.
Single Need Approach to Life Insurance The majority of families in America are inadequately insured. In some cases, for simplicity and ease of calculation, it has been said that, as a rule, individuals should carry life insurance equal to five or six times annual earnings. In addition, the following are a few of the more popular applications for life insurance to provide for a need that occurs as a result of a death.
Estate Settlement Needs Cash is needed for burial expenses, installment debt, administration expense, estate tax and in some cases expense for the last illness.
Readjustment Period Following the death of a head of family there is usually a one to two year period in which the family needs to continue to receive the same amount of income it would have received had the head of the family lived.
Dependency Period This period usually follows the readjustment period in that it lasts until the youngest child of the family reaches age 18.
Blackout Period This is the period when social security benefits to a surviving spouse are temporarily terminated. This occurs when the youngest child reaches age 16 and will not resume until the surviving spouse reaches age 60.
Special Needs Special needs may consist of a fund to pay off the mortgage, education fund for the children's education or an emergency fund for unexpected expenses.
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Retirement Fund In this instance, the head of a family may also wish to provide the surviving spouse with funds for retirement.
Insurable Interest A contract of life insurance must be based upon an insurable interest. Even though the term insurable interest is imprecise, a person is considered to have an insurable interest in another person's life if he or she can reasonably be expected to benefit economically from that person's continued life. The death of that person, the insured, would cause them, the beneficiary, to have an economic loss. The absence of an insurable interest would cause a life insurance contract to be unenforceable. Several important points should be observed about insurable interest.
Insurable Interest in One's Own Life Every person possesses an insurable interest to an unlimited extent in his or her own life and he or she can make the insurance payable to whomever he or she wishes. In these circumstances, the issue of insurable interest does not arise. The issue arises when an applicant is applying for insurance on someone else’s life and making themselves (applicant) the beneficiary. The insurance company will insist that the insurable interest of the beneficiary in the life of the insured is clear at the time of application.
Insurable Interest in Another Person's Life
Family and Marriage Relationships The relationship of husband and wife create an insurable interest on behalf of either party in the other's life. The courts have extended the relationship of parent and child, grandparent and grandchild, brothers and sisters, but have generally refused to go further. In-laws, for example, would not have an insurable interest. It is sometimes said that an insurable interest can be “blood, business or bucks.
Creditor-Debtor Relationships A creditor has an insurable interest in the life of his or her debtor.
Business Relationships Many types of business relationships other than creditor-debtor establish insurable interest. Examples would include employer-employee, business partners, corporations and officers in the corporation, etc. The interest is established when the application for the life insurance is made. The insurable interest is not required to exist at the time of the death of the insured, only at the time of application. For example, a fiancé might purchase insurance on his or her intended spouse. If the marriage did not take place and the insurance was kept in force, the insurance would be valid and would pay the beneficiary upon the death of the insured because an insurable interest did exist at the time of application.
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The beneficiary must show the insurable interest because the beneficiary is the person who would receive the money upon the death of the insured. At the time the application is being filled out, following the naming of the beneficiary, the next question on the application is, "What is the relationship between the beneficiary and the insured?" This is the time and the place the beneficiary shows that he or she has an insurable interest in the life of the insured.
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Chapter 2 Objectives Upon completion of this section, you will:
§ Be able to differentiate between the fundamental types and aspects of life insurance. § Be able to inform clients better about non-forfeiture, dividend, and settlement options. § Understand the tax treatment of the various components and scenarios of life insurance.
Chapter 2 Types of Life Insurance Products
Basic Life Insurance To the casual observer there might seem to be an almost limitless variety of life insurance products from which to choose. A quick glance through any insurance or financial publication will present the reader with a host of product advertisements that would seem to support this impression. The fact is there are only two basic forms of life insurance products: term and permanent. Over the years, insurers have developed variations of these two forms, so that today there is a life insurance product suited to meet just about any life insurance need. You will observe, as you go through this course, that the names given to insurance products aptly describe their nature. This should be particularly helpful when you take your examination. Take, for example, the names of the two basic types — life insurance is either provided through a term policy or a permanent (or whole life) policy. All life insurance policies, no matter how exotic their names, are a term policy, a whole life policy, or a combination of the two.
Term Insurance Term insurance provides pure life insurance protection and is designed to be used for a limited period of time or a limited term. There is no cash accumulation element to a term policy, which makes term insurance unsuitable for a life insurance program in which lifetime insurance protection or the growth of personal savings is part of the objective. On the other hand, term insurance has a very important role to play in meeting short-term insurance needs, and because it is less expensive than permanent insurance (because of the absence of a savings element) it is ideal for meeting those short-term needs.
Permanent or Whole Life Permanent or whole life insurance provides insurance protection but also has an accumulation element built into it. As the policy matures, a cash value accumulates, which is the policyowner's savings in the contract. As you will see more clearly in this lesson, permanent insurance is
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designed to be a permanent part of a person's insurance program; it is intended to remain in place for the policyowner's whole life. The cash value feature of a permanent life insurance policy is a good means of "forced savings" — this is often cited as one of the advantages of permanent insurance.
Classifications Life insurance, whether it is term or permanent, can be categorized by one of three classifications, which is determined by the market to which it is oriented. The three general classifications are: Ordinary Insurance. This insurance is any life insurance product that is sold to an individual policyowner and requires premium payments to be made no more frequently than on a monthly basis and usually on a quarterly, semiannual, or annual basis. The face amount may be $10,000 (but can be lower), though it is usually much higher. It is what we ordinarily think of when we think of life insurance. Industrial Insurance. This type of insurance is characterized by small face amounts, often $1,000 or less, with correspondingly small premiums that generally are collected weekly by the agent. It is also known as debit insurance. Group Life. This is any life insurance offered through a group arrangement such as an employer. A master policy is issued to the group, and each member's coverage is delineated by a certificate of coverage issued to the member. This Unit focuses on ordinary insurance, starting with term insurance.
Term Insurance
Understanding Term Insurance Term Insurance is the most basic type of life insurance. Term insurance is temporary life insurance protection that terminates at a specified future date. It is commonly said to represent pure protection because it offers life insurance with no cash value. Term Insurance provides only temporary protection from one to 20 years or until the insured reaches a specified age. When the policy terminates, the policyowner can expect no financial return from it. Term life is the simplest form of life insurance. It is pure death benefit with no inside financial values or specialized options. It is simple. There are a few varieties to match different kinds of needs that a person might have where term insurance is the right choice and the right fit for them. It’s based on the need they are buying it for as well as what their pocketbook will afford. Let’s take a closer look at them. Term insurance rates basically reflect the mortality charge. Thus, as a person's mortality charge increases with age, so do term premium rates. Because there is no savings element found in term policies, premiums in the younger years of a policyowner's life are low in comparison to a whole life policy. However, term insurance
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premium rates rise each time the policy is renewed, and so at older ages term insurance rates can be much higher than the rates for a whole life policy, assuming both policies were taken out at a younger age. As we will see when we review whole life policies, whole life premium rates are evened out, so that the rates remain level throughout the policy's life. Term insurance is available in several forms, each of which is designed to meet a specific need. When a policy is renewed, the new premium rate becomes that which is appropriate for the new attained age. The Figure below shows how this will result in increasingly higher premium levels.
Renewable Term All term policies are issued with a stated termination date. That date may be in a specified number of years (e.g., 10-year term) or to a stated age of the policyowner (term to age 65). Term policies may be issued for a period as short as one year. Term policies that have a renewable feature allow the policy-owner to renew the policy at the end of the term without providing evidence of insurability at that time. This is a good time to discuss the important concept of evidence of insurability. Any time a person applies for insurance, the insurer needs to know that the applicant is insurable. To assure itself of this and to reduce the chance of selection against the company, the insurer reserves the right to require the applicant to provide evidence of insurability. With an initial policy, such evidence is usually provided through the application. For larger policies, the insurer may also require a medical examination. The need for evidence of insurability becomes a greater issue when a policy is being renewed because of the possibility that the insured may have become uninsurable while the original policy was in effect. As we mentioned above, renewable term policies are characterized by the fact that the insured can renew the policy without being required to provide evidence of insurability. This renewability feature has a certain value. There is always the risk that the policyowner has become uninsurable. For that reason, there is a cost, paid by the policyowner, for having this renewability feature added to a term policy.
Convertibility An important feature, convertibility, is also added as an option to some term policies and gives the policyowner the right to convert the term policy to a whole life policy without providing evidence of insurability. These two options, renewability and convertibility, are available with term policies (for an additional cost that is made part of the premium). Next let's look at the actual different types of term contracts offered by most insurers.
Level Term Level term is insurance that maintains a level face amount during the policy's lifetime. Level term insurance is appropriate for insurance needs in which the amount of needed insurance remains level, but for only a limited period of time. For example, it is ideal for the family
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breadwinner who wants to provide extra financial protection while the children are growing up but will not need that extra protection when they have left home. It’s a type of death protection and a life insurance policy that provides the same amount of protection (face amount) for a specific period of time (1yr., 5yrs., 10yrs., 20yrs., etc.). At the end of the specific period of time, the policy expires. The applicant chooses the length of time they want the protection to last and the amount of death benefit they want to be paid to their beneficiary if they die. The premiums can be increasing or level depending on how a person prefers to pay for it over a period of time. Policies are available to accommodate increasing or level premium preferences. Term life is generally regarded as the least expensive way in the short term to provide dollars at death. Some people prefer to buy this pure protection and put aside other available money in savings and/or investments to provide dollars for future needs for education and retirement. If a term policy is renewable, the policy owner has the option to renew before the expiration date and no evidence of insurability is required. A One-Year Renewable Term policy, sometimes called Yearly Renewable Term (YRT) or Annual Renewable Term (ART) may be renewed at the end of each year. ART policies are the most popular of all term policies sold. The premium will increase each time it is renewed because the renewal premium will be based on the attained age of the person insured. While the cost today is generally the least one can pay for protection, the cost in the future as one grows older can become prohibitive. A Five-Year Renewable Term policy would have a premium increase at the sixth, eleventh, sixteenth and twenty-first year of the policy's life. Convertible Term is a term policy or feature in a term policy in which the policy owner can change the term coverage to “permanent” insurance with no evidence of insurability required. The insured may convert part or all of their term coverage. Premiums on the converted permanent policy will usually be based on the insured’s attained age at the time of their conversion. If the insurer allows the use of original age at the time of conversion, an additional premium may be assessed as a one-time makeup charge. Conversion options usually specify the time frame in which the conversions must be made. Some term policies, like Term to 65, are not designed to be renewed at or after age 65. However, almost all other term policies will be renewable. Most term policies will be convertible. If term policies do not have renewability and convertibility they will generally have lower premiums, but would leave the policyholder with exposure to the possible loss of their insurance at a time when they most need it or not being able to acquire new insurance because their health situation might be of a nature that they would not qualify for new insurance.
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Decreasing Term Insurance This is a term life insurance policy where the face amount decreases over a specific time period selected for the policy to provide protection. The death benefit amount and number of years over which it will decrease to zero is selected by the purchaser. With this type of policy, the premium remains level (as may be the case with a level term policy), but the face amount decreases each year. Decreasing term insurance is best suited for any situation where the need for life insurance protection decreases with time. The best example of this is with mortgages and loans. As the loan balance decreases, so does the need for protection. Since improvements in mortality and other factors have reduced level premium (10-, 20- or 30-year) rates dramatically, decreasing term insurance is not as popular. It is an excellent way to provide coverage for a loan where the amount of the loan is being amortized and the balance is reduced over a specified number of years, as in a home mortgage. It is sometimes called "mortgage cancellation" insurance. The premiums are generally level. It is used also as an educational protection policy where the older the child becomes the less the need for death dollars for higher education, assuming the parents have put aside dollars that have grown to replace the need for insurance dollars for the education fund along the way. Similarly, it has been used for family income replacement while children are younger and there is a full time non-income earning mom or dad at home. The amount of cash needed to create income if the working spouse dies becomes less as the child becomes older and there is less time for additional income being needed to get the child to age 18 or 21 if a college student.
Reentry Term This is a newer type of term insurance that some companies make available. With this policy, the premiums are based on a low-rate schedule. Under the terms of this policy the insured must demonstrate evidence of insurability, usually every one to five years. It is generally yearly renewable term (YRT) life insurance under which an insured can usually re-apply for term insurance every fifth year at a lower premium than the guaranteed renewal rate. If the insured's health is good (as documented by evidence of insurability), the guaranteed renewable term premium can be reduced. If not, the guaranteed rate must be continued to be paid on renewal.
Credit Life Insurance – Individual Credit Life Insurance is a specialized type of Decreasing Term Life Insurance. It is insurance on the life of a debtor that would pay what is owed on the loan in the event the debtor dies (sometimes disability protection is included, as well). The amount of the credit life insurance may not, at any time, exceed the amount of the debt. If credit life is a requirement for a loan, the debtor must be allowed to substitute current insurance they own and/or choose their own insurer. Many times, individual term insurance
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bought privately can be less expensive. A person should look at both to see which meets their needs best and is more affordable. Credit life may be issued as:
Individual policies These are policies issued to the debtor on the decreasing term plan. The creditor is the beneficiary and the debtor pays the premiums.
Joint policies Unlike joint life insurance (discussed later), joint credit life policies may be issued only on spouses or business partners. The policy would pay off the debt that a husband and wife or partners have as an obligation together.
Group policies These are issued to creditors, providing insurance on the lives of debtors on the decreasing term plan. The creditor owns the group credit life policy and the premiums are paid by the debtor. Premiums for group credit life policies are usually based on a flat rate unrelated to the borrower's age. As mentioned above, life insurance cash values are not taxable income as long as they do not exceed the sum of all premiums paid by the insured (the insured's cost basis). The value of any cash value in excess of the cost basis represents taxable income. The use of decreasing term insurance to cover a loan or mortgage is the basic principle behind credit life insurance. Available since the 1930s, this is decreasing term insurance that is tied to a personal loan or mortgage. If the loan is paid off early, excess premiums are refunded to the insured. Credit insurance cannot exceed the value of the loan.
Whole Life Insurance
Understanding Whole Life Insurance It’s the oldest and the basic model on which other cash accumulation policy varieties are based. It’s known by many names including Continuous Premium Whole Life, Ordinary, or Straight Life. It was created as an answer to the need for “leveling out” the increasing premiums that were required to provide term insurance for a person’s entire life, regardless when death occurred. One can only imagine what the premium for one year of term would be at age 90 for example, even if it was available. Few could afford to maintain the coverage to be in force when they died. Level premiums are payable throughout the insured's lifetime and coverage continues until the insured's death. In essence, one pays more now while they are working and earning an income than they would for term insurance for one year, so that in the later years of life when most are no longer working and earning an income, the premiums could be afforded and the death benefit stay in force until death. Cash values are accumulated inside the policy essentially from
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overpayment in the earlier years of needed premiums for the pure death benefit and the companies return on investing of the overpayments. All Whole Life insurance policies build cash values. They build slower in traditional Whole Life policies than in other types of limited pay Whole Life policies because one is spreading the premium payments over an entire lifetime, causing the premiums to be lower. In all Whole Life policies, cash values will equal the face amount of the policy at age 100. One is considered statistically dead at age 100 and the policy endows. When it endows the insured receives payment of the face amount of their policy without having to be dead. To understand the nature of whole life insurance, and indeed the difference between whole life and term insurance, it is important to understand the concept of amount at risk. The amount at risk is the value of the risk that the insured represents at any particular time. In a sense, it is the amount of money an insurer would have to pay out of its pocket, its reserves, to pay a claim. A person represents a greater risk with each higher age, and this is reflected in a mortality charge that increases with age. With a term policy, the policyowner is expected to pay that increasingly higher mortality charge each year. The result is that term insurance rates increase each year, although insurers are able to even out the rates.
Term Life - Risk Term life policies represent pure protection and that they have no savings characteristics. A term policy does not generate a cash value. With a $100,000 term policy, the insurer's amount at risk is $100,000, which means that if the insured dies while the policy is in force, the insurer will have to pay $100,000 out of its reserves. Each year, the insured grows older and draws closer to death. Thus, the mortality charge increases and must be reflected in the cost of the premium. With permanent insurance, the net amount at risk decreases each year. The difference between the face amount and the current amount at risk is equal to the policy's cash value. An important feature of cash value is that the policyowner may borrow from them. As the amount at risk decreases, the cost to the policyowner decreases. This decrease partially offsets the increasing cost of mortality. The result is that the two forces counterbalance each other, resulting in a partial leveling off of the premium rate. The premium rate is totally leveled off by the development of the cash value.
Permanent Life Premiums and Cash Value Features A permanent life insurance premium remains level throughout the life of the contract even though the risk of death (and thus the mortality charge) increases with age. To accomplish this, insurers actually charge more than is required to cover the policyowner's mortality risk in the early years of the policy and subsequently charge less than the risk would require in the insured's later years. The cash value represents a reserve fund, which in a sense represents excess premiums paid in the policy's early years that are subsequently used to offset the need for greater premiums in later years. This reserve is viewed as a liability by the insurer, a liability that must be paid either at the insured's death or policy surrender.
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Cash Value Features An important feature of cash values is that the policyowner may borrow from them. The amount of the policy loan, of course, cannot exceed the amount of cash value. Insurers charge a nominal rate of interest on policy loans for the simple reason that cash values are an important part of the funding of a life policy. If the cash value is removed from the company, it does not have that money to help meet its policy funding requirements. Put differently, the interest charged to the insured represents the interest the insurer would have received from its investments if the cash value had been left with the company. If an insured dies before the policy loan is paid off, the face value paid to the beneficiary is reduced by the amount of the loan and any interest accrued on it.
Whole Life As previously mentioned, Whole Life insurance policies build cash values. They build more slowly in traditional Whole Life policies than in other types of limited pay Whole Life policies because one is spreading the premium payments over an entire lifetime, causing the premiums to be lower. In all Whole Life policies, cash values will equal the face amount of the policy at age 100. One is considered statistically dead at age 100 and the policy endows. When it endows the insured receives payment of the face amount of their policy without having to be dead.
Whole Life - Risks The amount at risk with any whole life policy is the difference between the face amount of the policy and the cash value at any point in time. As the cash value increases, the insurer's amount at risk decreases. The policyowner is entitled to receive the cash value even if the policy is surrendered. The figure below illustrates the relationship between cash values and amount at risk (or pure insurance protection).
Whole Life Cash Values Basically, cash value builds up in the early years of a policy to subsidize the cost of protection during the later years. Cash values are a tax-free savings opportunity. In other words, there are no federal or state taxes imposed on this inside buildup, although Congress periodically threatens to look at it as a source of taxable funds. The sole exception to this lies with single premium life insurance, which will be discussed shortly. All whole life policies are structured so that the cash value gradually approaches the value of the face amount until at age 100 the two are equal. At that point the insurer's amount at risk is 0, and the policy is said to endow (or mature). Because the face value and the cash value are equal, there is no longer any purpose for the insurer to hold on to the cash value, and the insurer will pay the insured the value of the policy. There are several types of whole life policies, each designed to meet different needs.
Straight and Modified Life The oldest, and most common, form of whole life insurance is the straight life policy. This is the vanilla ice cream of whole life insurance policies. Characteristics of a straight life policy include:
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§ Equal amount premium payments are spread out for the life of the policy (to age 100). § Cash values grow steadily.
Modified Life This is a form of whole life insurance in which premiums are lower for a specified period of time, such as five years, after which the premium is higher during the remainder of the policy term. The starting premium is called the "initial" premium and the higher premium is called the "ultimate" premium. The purpose of the policy is to allow individuals with current limited income to buy permanent life insurance. Cash values are lower in the initial premium phase of the policy. When buying this policy, the insured should have the income potential to absorb the one-time premium increase that would occur in the 5th year in our example. This is particularly popular with people who have a lower budget in their younger years.
Graded Premium Whole Life This policy is similar to the Modified Whole Life we just discussed except the premium increases from the initial premium to ultimate premium in a series of annual steps or "grades" rather than one, single increase. The “graded” premium might start low and increase each year for 10 years until it reached the ultimate premium. After this point, the premium would remain level to age 100 at which time it would endow for the face amount just as in Whole Life.
Limited Pay Life These are Whole Life policies that have all the characteristics of traditional Whole Life with the exception that the premium payment period is limited to a certain number of years. For the same face amount, a higher premium is collected during a shorter period of time, causing the cash values to rise faster. The cash values still equal the face amount at age 100 and the policy endows at age 100. Essentially, the premiums that would have been due on an Ordinary Whole Life policy are condensed into a shorter time frame. Many people prefer this so that premiums stop at a given age, such as 65, or in 20 years, etc. This way they do not have a premium obligation during future years when income or resources may be limited. With a limited pay whole life policy, the premium paying period is shorter than with a straight life policy — although coverage continues for the insured's lifetime. Premium payments are higher than with a straight life policy of comparable face amount. Two of the more common forms of limited pay policies are the 20-pay life, in which premiums are paid for 20 years, and life-paid-up-at-65, in which premiums are paid to age 65. It is important to note that limited pay policies do not endow any earlier than do straight life policies.
§ All whole life policies endow, or mature, at age 100. § Premium payments are made for a limited period of time. § Cash values accumulate faster than they do with a straight life policy.
30 Pay Life, 20 Pay Life, 15 Pay Life or 10 Pay Life These are also other varieties of limited pay Whole Life policies. Their premium paying time durations are limited to the period chosen. Like Life Paid up at 65 policies, at the end of the period chosen, premiums stop and the insured has a paid-up policy which also endows at age
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100. The shorter the period of premium payments, the higher the premiums and the faster the increase in early cash values.
Life Paid Up at 65 This is an example of a limited pay Whole Life policy. The premiums are paid only until the insured reaches age 65. Premiums stop, but the policy remains in force until the insured dies or reaches age 100. Premiums are higher than Ordinary Whole Life and cash values rise faster in the early years than Ordinary Whole Life due to the additional premiums that are being paid in a shorter period of time.
Single Pay Life This is the ultimate limited pay policy. Premiums are paid with one payment when the policy is purchased. The policy has immediate cash values but the cash values will not equal the face amount until age 100 when it also endows. After the initial premium is paid, no further premiums are due. Therefore, the policy has no grace period and is lapse proof. We discuss grace periods and lapses more fully later on in your course. An extreme type of limited pay life the single premium life policy is paid for with one premium payment. Cash values accumulate at a very high rate. In late 1988, Congress passed legislation that reduced the attractiveness of single premium life. Recognizing that many people were buying SPL solely for its tax advantages, Congress reclassified the product as a modified endowment. The most significant consequence of this is that any withdrawal of the cash value is treated first as income to the policyholder. Only after all earnings have been paid will the withdrawal be treated as a tax-free return of the owner's premiums.
Industrial Life Insurance Face amount of $1,000 or less. The agent collects premiums weekly. The words "Industrial Policy" must appear on the face of the policy. The agent is usually assigned an area to service, called a "debit." Agents are sometimes called Home Service Agents.
Combination Policies
Developing Policies Insurers are a creative lot, especially when it comes to creating insurance programs to meet particular insurance needs. Although term and whole life insurance are the two basic forms of insurance, insurers have developed policies that combine features of both. Known as combination policies, they are an important means of meeting specific life insurance needs. A combination policy combines a whole life policy with a term policy. Let's look at the more popular combination policies available today.
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Whole Life PLUS Term Policy
Family Policy A Family Policy is any life insurance policy that insures the provider with whole life and the spouse and/or children with term riders. The Family Policy insures all members of the family under one policy. It is usually packaged in units: a certain amount of permanent insurance is chosen on the primary insured (provider or breadwinner). This amount will determine the amount of term coverage on the spouse and on each child. One premium is collected for the combined coverages in the policy. The primary insured will have permanent insurance (usually Whole Life) and the spouse and each child will have term insurance. All children are covered under one premium. Newborn children are added to the policy after living fourteen days with no increase in the premium. The family must notify the insurer, in writing, to add a new born or adopted child. The death benefits are paid lump sum immediately following the death of an insured. It is possible for the spouse and/or child to die after their term insurance has expired and no benefits would be paid. Probably the most common form of combination policy is the family policy. Under a family policy, a whole life policy is issued to one parent and term policies are issued on the spouse and each child. As new children are born, they are automatically covered. The term insurance is usually term to 65 for the spouse and term to 18 or 21 for each child. A convertibility option is added to each term policy to protect the children's insurability. Family policies are an economical way to protect one's entire family. Premiums are based upon the age of the primary insured spouse.
Family Income The purpose of the family income policy is to guarantee that a specified income will be provided to the family in the event of the key wage earner's premature death. It is a decreasing term policy attached as a rider to an underlying whole life foundation policy that will provide the funds needed to provide a predetermined income to the beneficiary for the remainder of a specified period of time. For example, if Fred Gregory buys a 20-year family income policy and dies two years later, the monthly income benefit would be paid for the following 18 years; death 10 years after issue would call for payments for the remaining 10 years; death at or after 20 years would produce no income benefit payments.
Family Maintenance Related to the family income policy is the family maintenance policy. It differs from the family income policy only in that the monthly income is provided for a set period of time. It uses a level term policy rider added to the underlying foundation of whole life rather than a decreasing term rider. Using our example from above, the family maintenance policy would provide monthly income for 20 years, whether the father died today or in 19 years. In our example above, if the father died in 19 years the family would receive monthly income for one year. With a family maintenance policy, it would continue for 20 years.
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Versions of Whole Life
Varieties of Whole Life
Joint Life This is a whole life policy that covers two or more lives and pays the death benefit upon the death of the first of the two or more lives covered under the policy.
Joint Life (first-to-die) Two people are insured in one policy. The policy is usually purchased because the premium is lower than it would be for two separate policies. The ages of the two insureds are "averaged" according to each company's formula and one premium is charged for both lives. It is whole life insurance and pays the face amount when the first insured dies. The survivor will be offered a new policy (same face amount) without evidence of insurability but will be charged at their attained age. In the event both insureds die at the same time the face amount is paid to the beneficiaries on each life. For example, a face amount policy of $50,000 would pay a total of $100,000 in the case of simultaneous death.
Joint Life and Survivorship (second-to-die) A variation of the Joint Life policy is the Survivorship policy, sometimes called the Last Survivor Policy or "Second-to-Die" Policy. This policy insures two lives but the death benefit is paid only upon the death of the second insured Often, these survivorship policies are purchased to help the children pay estate taxes after the death of the second parent. This policy is especially useful in Estate Planning.
Extra Ordinary Life A policy offered by mutual companies with a lower premium than straight Whole Life. Even though the face amount is allowed to decrease, the total death benefit is kept level by the owner's choice of dividend option. The owner agrees to use all dividends to purchase paid-up additional insurance. As the face amount falls the paid-up additional insurance keeps the death benefit level. This policy is sometimes called "Enhanced Ordinary Life" or "Economatic Life."
Indexed Whole Life There are other varieties of whole life. As mentioned earlier, you'll note that the names of these variations generally explain their nature. An indexed whole life policy is one whose face amount increases in relation to increases in the Consumer Price Index. The insured will be responsible for the increase in premiums required to fund the higher amount. When the policy is purchased the buyer may choose to pay a higher premium that remains level and thereafter receive increases in the face amount with no additional premium increases or they may pay a lower initial premium and agree to pay premium increases when the CPI calls for a higher face amount. Any failure to pay for an increased amount of insurance would void the agreement that calls for face amount increases. In all cases no evidence of insurability would be required for any
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increases in the face amount. This policy was designed to offset the impact of inflation upon a person's life insurance. The key advantage to this is that even if the insured becomes uninsurable, he or she can be assured that the existing policy will grow to keep pace with inflation. Generally, if the CPI decreases, the policy benefit remains level.
Graded Premium Whole Life This is a form of modified whole life, except that premiums increase steadily rather than in one single jump. Cash values accumulate very slowly, because the premium in the early years can be as much as 50 percent less than that for a comparable straight life policy.
Last Survivor Life In contrast to a joint life policy, a last survivor policy pays the death benefit upon the death of the last of the two or more lives covered under the policy. This is often referred to as a survivorship life or last-to-die policy.
Juvenile Insurance State laws prohibit the sale of insurance to minors. Nonetheless, there are many important reasons to want a child to "own" a policy. Juvenile policies are issued to an adult family member. When the child reaches the age of majority, the policy is assigned to the child. An important objective of juvenile insurance is to protect the child's insurability. A variation of the juvenile policy is the “jumping juvenile” policy. This policy requires premiums in the early years (until the child reaches 21) that are much higher than actually required. As a result, cash values accumulate rapidly, providing a good source of funds from which to borrow to provide for college expenses. At age 21 the policy face amount "jumps" in value up to 5 times its original amount. The premium level, high in the early years, remains level and adequate for the new higher face amount.
§ Protect the insurability of children. Insurance must be written on children before they develop health problems that would make them uninsurable. Options are usually placed in the policy that would enable the insured to purchase additional insurance at specified times regardless of bad health.
§ Provide for postmortem expenses in the event of the child's death. Juvenile
Policies often have a Payor Provision (Rider) attached. This provision stipulates that, if the adult premium payor dies or is disabled before the child reaches a certain age (usually 21), the premiums are waived until the child reaches that certain age or until the policy matures.
Retirement Income This is a combination of a retirement annuity and a decreasing term policy. The decreasing term insurance provides a benefit in the event the insured dies before retirement, which is used to complete the retirement annuity and thus provide retirement income for the beneficiary.
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Indeterminate Premium Policies Policies may be sold that allow a redetermination of premium periodically, usually on an annual basis. The maximum premium must be stated.
Endowment Insurance An endowment policy is a life insurance policy where the cash value equals the face amount (death benefit) at the end of the policy period. A 20-year endowment policy, for example, gives life insurance protection for the 20 years for the full face amount. If the insured dies during the endowment period, the death benefit would be paid, as in Whole Life. If the insured lives to the end of the 20 years, the face amount would be paid to the owner as it endows. The gain (face amount minus premiums) would be taxed as ordinary income. Endowments are sold for various time periods and are often used to accumulate funds for a child's education. However, they can be used to build a lump sum payment for any purpose. In all endowment policies, the guaranteed cash value accumulations will equal the face amount at the end of the endowment period. Tax Law Impact Prior to the Tax Reform Act of 1984, endowment policies were a very popular insurance product. However, this tax law brought changes that in essence impose adverse tax consequences on endowment policies and thus have effectively eliminated the sale of them. The law did not impact existing endowment policies, and since there are a lot of them out there, it is important that you understand what they are. An endowment policy pays a stated face amount in the event a policyowner dies before reaching a stated age, but it also pays that face amount to the policyowner in the event he or she reaches that stated age. Often, the age of endowment was 65, to coincide with retirement. It can be compared to a whole life policy that endows at some age much earlier than 100. The Tax Reform Act of 1984 placed limitations on the rate at which a policy cash value can accumulate, and virtually all endowment policies violated this requirement. Cash values accumulate at a much faster rate in an endowment policy than with any other type of life insurance policy. Although an endowment looks like a whole life policy moving in the fast lane, technically it was a combination of a decreasing term policy and a pure endowment. A pure endowment is an insurance product that pays the face amount only if the insured reaches the endowment age.
Flexible Premium & Interest-Sensitive Life Products We will close our review of life insurance policies by looking at the flexible premium and interest sensitive products. A flexible premium product is one that offers the policyowner the ability to adjust, at will, the level of premium he or she pays on a policy. An interest sensitive life product is any product that in some way is affected, directly, by inflation and the effect it has on interest rates and securities prices. In fact, it was the high inflation of the 1970s that spawned the growth of these products.
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The list below itemizes the various types of flexible premium and interest-sensitive products. Two of them, universal life and variable life, have received the lion's share of media attention, but all are important.
§ Adjustable Whole Life § Universal Life § Variable Life § Variable Universal Life
Conservative Industry The life insurance industry has been historically noted as being very conservative. Considering the nature of its business, this is understandable. Insurers are in the business of making long-term promises to pay out large amounts of money. To support these guarantees, company actuaries base their premium rates on conservative interest assumptions. If the company earns more than the assumed rate, the company may cautiously consider lowering its rates on future policies. But, once a traditional policy is sold, there is no possibility that the policyowner will experience a rate change to an existing policy. Of course, this policy of secure rates works both ways. If prevailing interest rates drop below those that the actuaries assume the company will earn, the insurer may find that its rates are too low. Nonetheless, it cannot increase rates on existing policies. In this same respect, insurers traditionally have not allowed policyowners to adjust the levels of the premium once a policy was issued. The main reason for this was because the technology did not exist to permit insurers to keep track of all the calculations that would be required to monitor changes in premium levels and the effect those changes would have on cash values.
Interest Rates Prior to the 1970s, interest rates in the United States were fairly stable, so the 3 or 4 percent rates that actuaries were using as an interest assumption were acceptable. Remember, life insurance premiums are made up of three factors: a mortality charge that is increased by an expense charge and decreased by a rate of interest the company expects to earn. Beginning in the 1970s, inflation and, therefore, interest rates began to heat up. As banks and investment companies began to increase the rate of interest they credited to peoples' investments, the life insurance industry came under criticism for offering a poor investment. This charge was focused primarily at the cash values that insurance policies were generating. With an assumed interest growth of 3 or 4 percent, life insurance cash values did not appear to represent a profitable investment. In response to a demand for market competitive products, the life insurance companies developed new approaches to offset the poor image associated with fixed interest cash value buildup. The result is known as variable-premium or interest-sensitive policies, which have dramatically transformed life insurance into a key product in the investment field.
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Adjustable Life Coinciding with the demand for greater policy flexibility and more competitive rates of return was the advent of enhanced computer technology, which has provided the technical support needed to make today's high-tech life products possible. The adjustable life policy, introduced in 1971, was the first life product to be characterized by policy flexibility. At any point in time, adjustable life is a level premium, level death benefit life insurance policy. It can be structured either as a term or whole life policy. The key difference between adjustable life and traditional life products is that, with adjustable life, the policyowner can change the plan by requesting that the insurer change the policy configuration. Adjustments can be made prospectively only, affecting the future but in no way amending the past. Adjustments can include increasing or decreasing premiums and the face amount. Increasing the face amount may require evidence of insurability. Adjustable life is designed to address the two main concerns of policyholders: how much insurance does one need and how can they pay for it? This type of Whole Life policy permits changes to be made in the following areas:
§ Amount of life insurance. § Period of protection. § Amount of premium. § Duration of premium-paying period.
This type of insurance is frequently called "Life Cycle" insurance because policy changes may be made to conform to different periods in the insured’s life. Within certain limits, the policyowner can make the following adjustments as the situations warrants:
§ Reduce or increase the amount of insurance. § Shorten or lengthen the period of protection. § Increase or decrease the premiums paid. § Lengthen or shorten the period for paying of premiums.
A cost of living provision can also be attached to the Adjustable Life Policy and this will in fact maintain the real purchasing power of the insurance.
Universal Life Universal life (UL) evolved from the flexibility of adjustable life, but it went further and offered a truly interest-competitive feature. Introduced in 1979, UL was the first whole life insurance product to unbundle the pure protection and savings elements of traditional products. Traditional whole life products combine pure protection with the savings element. Universal life policies are said to be transparent, meaning that each of the three premium expense factors is treated separately. With UL, a part of each premium payment is used to pay insurance company expenses and the cost of the pure protection (i.e., mortality charge), and any remaining premium
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is credited to the cash value. A policy that insures the life of a person and also allows the cash value to possibly earn more than traditional Whole Life policies. Unlike Whole Life, face amounts are adjustable, premiums are flexible and the buyer can withdraw all or part of the cash values (partial surrender). Universal Life is an adjustable life insurance policy with three distinctive characteristics: Premiums are flexible, not fixed. Protection is adjustable and the insurance company’s expenses and other charges are reported to the purchaser. This policy is sometimes referred to as "unbundled life insurance" because the following three basic elements are separately identified in the policy and in an annual statement to the policyholder. The costs of the insurance protection. (Annual term insurance. Earnings on the excess premium that the company is investing for the insured. A low, minimum interest rate is guaranteed but the current interest rate is paid if it is higher than minimum. Periodically, the insurer withdraws an amount from the cash values to cover expenses and to pay premiums for the annually renewable term coverage. Universal Life is an annual renewable term contract plus an investment fund like a fixed annuity. This allows a buyer to "buy term and invest the difference," meaning they are investing the money saved by not choosing a Whole Life policy with its higher premium. The insured has no investment options; the company like a blind trust invests the policy’s cash values. Face amount of insurance can be changed up or down. Of course, a minimum amount must be maintained in the cash values to fund the amount of life insurance protection desired. Unlike a Whole Life policy, a Universal Life policy allows partial withdrawals from the cash values. A Whole Life policy will pay the face amount to a beneficiary, but not the cash values. A Universal Life policy pays both the face amount and the cash value account. NOTE: Because the policy owner has no investment choices in Universal Life policies, the agent is not required to have additional training or licenses beyond the Life and Health License.
Mortality Charges Remember: Premium payments consist of a mortality charge, an expense factor, and an interest factor. By unbundling the premium, the insurer makes distinct charges for mortality and expenses and lets the remaining premium earn interest in any number of investment-competitive funds. If the policyowner so chooses, he or she need only make a premium payment sufficient to pay the mortality and expense charge. Of course, in that case, the policy is nothing more than a term policy.
Policy Flexibility The point is that a UL policy offers a great deal of flexibility. If the policyowner so chooses, he or she may make a small premium payment or none at all, as long as there are sufficient cash values to pay required company charges. In this latter case, the insurer would dip into the policy's cash value to retrieve funds sufficient to pay the mortality and expense charges.
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Rather than minimize premium payments, most UL policyowners try to maximize their premium in order to put as much into the cash value fund as possible. The reason for this is that UL policies offer a competitive interest rate, especially when compared to traditional whole life products.
Accumulating Cash Value Remember: Cash values accumulate on a tax-free basis. Because the potential for tax abuse exists in a situation like this, the IRS imposes requirements that demand that a certain relationship must exist between the cash value and the face amount. Basically, in order for UL be considered insurance (and thus eligible for favorable tax treatment), there is a minimum amount of pure insurance needed in the policy. This minimum level of pure protection is known as the corridor of insurance. The two options below illustrate the two types of policy configurations allowed by the IRS: In either case, the important point is that a minimum amount of pure insurance protection must always be present. Insurer's generally permit a moderate increase in the face amount to occur without requiring evidence of insurability; evidence of insurability may be required if the increase is significant. All of the flexible premium and interest sensitive whole life products we've looked at so far resemble traditional whole life in at least one respect. The interest rates credited to the cash value are fixed, meaning that they are stated in advance and the insurer is obligated to credit those rates until it announces new rates. The insurer assumes the risk that the rates it earns from its investments may not support the rates it currently guarantees. For this reason, insurers still tend to be somewhat conservative in the rates they announce, although the rates of interest-sensitive products are still much higher currently than has been the case with traditional whole life policies.
Variable Life Insurance Many insurance consumers believe that, if given the opportunity, they could earn higher rates still if they could invest in equities, particularly stocks and bonds. Variable life insurance, first offered in the U.S. in 1976, offers that opportunity. Variable life insurance is an equity-based whole life product that offers the policyowner the potential of dramatic gain in the cash value as well as the possibility of loss. From another perspective, a variable life insurance policy is a whole life policy with an attached investment fund like a variable annuity. The buyer assumes responsibility for making investment choices the policy has fixed premiums and a guaranteed minimum death benefit, which is the face amount of the policy. The higher the return on the investments made, the higher the death benefit or surrender value of the policy. Because the cash values are at risk, State law limits the amount that can be borrowed at 75%. Even though a Variable Life policy is a life insurance contract, the U. S. government considers it a securities instrument because there is an investment risk to the policy.
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It is regulated by both state and national governments. The federal Securities and Exchange Commission (SEC) regulates Variable Life Policies. In addition to state regulation, the life insurance agent must be a registered representative of the Financial Industry Regulatory Authority (FINRA). This is accomplished by passing the Series 6 exam administered by FINRA. Any variable product sold in insurance, whether it is life insurance or an annuity contract will contain the three elements: securities, options, and license requirements.
Variable Life's Purpose Variable live insurance (VLI) is designed to combine the traditional protection and accumulation elements of life insurance with the growth potential associated with equities, particularly corporate stocks and bonds. With variable life, the policyowner's premiums are invested in a separate account of the insurer, which is separate from the general account upon which the insurer's fixed-interest products are based. The insurer offers no guarantees as to the performance of assets in its separate account. Usually the insurer offers a variety of separate accounts from which to choose; each one has a different investment objective. With VLI, it is the policyowner who assumes the investment risk, not the insurer (as is the case with fixed interest policies).
Variable Life Cash Values Because the cash value can increase or decrease, the net amount at risk can go up or down. This, in turn, can affect the face amount of the policy. A VLI policy is a whole life policy under which the cash value and/or death benefit can increase or decrease to reflect the investment experience of the underlying separate account. Cash values must be calculated monthly and death benefits must be calculated annually. In most respects, the VLI policy functions in the same manner as a traditional whole life policy. Most importantly, fixed premiums are payable on a regular basis. A lapsed policy may be reinstated (that is, reactivated), provided the policyowner provides evidence of insurability and the insurer collects past-due premiums equal to no less than 110 percent of the cash value increase that would have been in place at the time of reinstatement had the policy not been lapsed from the policyowner. This latter rule is designed to discourage policyowners from playing the market by lapsing their policy when equity prices are going down and reinstating it when prices rise. Policyowners may take out a policy loan against the cash value of up to 90 percent of the cash value. VLI policies contain a conversion feature that allows a policyowner to convert to a whole life policy within the first 24 months of the policy's effective date.
Regulation of Variable Life While most insurance regulation occurs at the state level, regulation of variable life insurance rests heavily at the federal level. This is because variable contracts are considered equity products, and all equity products are regulated by the Securities Exchange Commission. Variable contracts are regulated by the Securities Exchange Commission. It is important to note that anyone selling equity-based products must be registered with the Financial Industry Regulatory Authority (FINRA), and must have either a Series 6 or Series 7 registration. Some states require producers to also have a Series 63 ("Blue Sky") registration.
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FINRA is the 2007 successor to the National Association of Securities Dealers, Inc. (NASD) created in 1938 under the Maloney Act, amendment to the 1934 Securities Exchange Act. To the information on SEC and FINRA regulation of variable contracts, we should add one additional piece of information. VLI is defined as life insurance under Internal Revenue Code Rule 6e-2, provided the following conditions apply:
§ It must be funded by a life insurance company separate account. § It must provide death benefits and cash values that reflect investment experience. § It must provide a minimum death benefit guarantee. § The mortality and expense charges must be separate from the investment portion.
Variable Universal Life It was only a matter of time before the policy flexibility of universal life was combined with the investment potential of variable life. Variable Universal Life, introduced in the past several years, is now taking center stage as one of the newer whole life product on the market. As with variable life, agents wishing to sell VUL must be properly licensed with their state and registered with the FINRA. A VUL policy offers the best of both worlds:
§ Flexible premiums. § Investment control of cash value.
Indexed Universal Life Indexed univeral life insurance is a lot like universal life insurance however it does have a couple of wrinkles not found in traditional universal insurance policies. Universal life insurance comes in many different forms, from your basic fixed-rate policy to variable models that allow the policy holder to select various equity accounts in which they can invest. An indexed universal life insurance policy gives the policy holder the opportunity to allocate cash value amounts to either a fixed account or an equity index account. Indexed policies offer a variety of popular indexes to choose from, such as the S&P 500 and the Nasdaq 100. Indexed policies allow policy holders to decide the percentage of their funds that they wish to allocate to fixed and indexed portions. Also, these types of universal insurance policies typically guarantee the principal amount in the indexed portion, but cap the maximum return that a policy holder can receive in the account. Since these policies are seen as a "hybrid" universal life insurance policy, they are usually not very expensive (due to lack of mangement), and are safer than an average variable universal life insurance policy. However, the upside potential is also limited when compared to variable policies which we will take a look at later. Indexed Universal Life is now taking center stage as the newest whole life product on the market.
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Policy Provisions of Life Insurance Policies Many agents have never read the required policy provisions that are contained in every policy sold. It is important to note that policy provisions are in fact contractual provisions and govern what the policyowner can and cannot do with the policy.
Overview Here is an overview of some of the policy provisions:
§ Ownership Clause. § Entire Contract Clause. § Incontestable Clause. § Suicide Clause. § Grace Period. § Reinstatement Clause. § Misstatement of Age. § Beneficiary Designation. § Change of Plan Provision.
Ownership Clause The owner of a Life Insurance Policy can be the applicant, the insured, or the beneficiary. In most cases, the applicant and insured are the same person. Under the Ownership Clause, the policyowner possesses all contractual rights in the policy while the insured is still alive. These rights include the selection of a settlement option, naming and changing the beneficiary designation, election of dividend options, and other rights. These contractual rights typically can be exercised without the beneficiary's consent. In addition, the Ownership Clause provides for a change in ownership. The policyowner can designate a new owner by filling out an appropriate form with the company. The insurer may require that the Life Insurance Policy be endorsed to show the name of the new owner.
Entire Contract Clause The Entire Contract Clause states that the Life Insurance Policy and attached application constitute the complete contract between the insurer and policyowner. No statement can be used by the insurer to void the policy unless the statement is a material misrepresentation and is part of the application. In addition, the terms of the policy cannot be changed by any officer of the company unless the policyowner agrees to the change.
Incontestable Clause Under the Incontestable Clause, the company cannot contest the policy after the policy has been in force two years during the insured's lifetime. The insurance company has two years to discover any irregularities in the contract, such as a material misrepresentation or concealment. If the insured dies after that time, the death claim must be paid. For example, if John conceals a cancer operation when the application is filled out and dies after expiration of the incontestable period, the death claim WILL be paid.
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The purpose of the incontestable clause is to protect the beneficiary if the insurance company tries to deny payment of the death claim years after the policy is issued. Since the insured is dead, allegations by the insurer concerning statements made in connection with the application cannot be easily refuted. After the incontestable period has expired, with few exceptions, the company must pay the death claim.
Suicide Clause A typical Suicide Clause states that the face amount of the policy will not be paid if the insured commits suicide within two years after the policy is issued. The only payment is a refund of the premiums. The purpose of the Suicide Clause is to reduce adverse selection against the insurer by providing the insurer some protection against an individual who purchases a Life Insurance Policy with the intention of committing suicide.
Grace Period A Grace Period is another important contractual provision. A typical Grace Period gives the policyowner thirty-one days to pay an overdue premium. The life insurance remains in force during the Grace Period. If death occurs during the Grace Period, the overdue premium usually is deducted from the policy proceeds.
Reinstatement Clause If the premium is not paid during the grace period, a life insurance policy may lapse for nonpayment of premiums. The Reinstatement Clause allows the policyowner the right to reinstatement of a lapsed policy under certain conditions:
§ The insured must provide evidence of insurability, a condition that insurers often waive for lapses of less than two months.
§ All overdue premiums plus interest must be paid. § A policy loan must be repaid or reinstated. § The policy has not been surrendered for its cash value. § The lapsed policy must be reinstated within five years.
If the policyowner wishes to continue the same type of life insurance coverage, it usually is more economical to reinstate a policy than to buy a new one. This is because a new policy is likely to have a higher premium, since it will be issued when the insured is older.
Misstatement of Age The insured's age may be misstated in the application. Under the Misstatement Clause, the amount paid is the amount of life insurance that the premium would have purchased at the insured's correct age. Example: Assume that Mary's correct age is thirty but is incorrectly recorded in the application as age twenty-nine and the premium for an ordinary life application at age twenty-nine is $20.00
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per $1,000.00 and $21.00 per $1,000.00 at age thirty. If Jane has $15,000.00 of Ordinary Life Insurance and dies, only 14/15ths of the proceeds will be paid, or $14,000.00.
Beneficiary Designation The beneficiary is the person or party named in the policy to receive the policy proceeds. There are numerous Beneficiary Designations in life insurance such as:
§ The Primary Beneficiary is the first party who is entitled to receive the proceeds at the insured's death.
§ The Contingent Beneficiary is the beneficiary entitled to proceeds if the primary beneficiary is not alive.
§ A Revocable Beneficiary designation means that the policyowner has the right to change the Beneficiary Designation without the beneficiary's consent.
§ An Irrevocable Beneficiary designation means that the policyowner cannot change the beneficiary without the irrevocable beneficiary's consent.
§ A Specific Beneficiary designation means that the beneficiary is named and can be identified. For example, Martha Smith may be specifically named to receive the policy proceeds if her husband should die.
§ A Class Beneficiary designation means that a specific individual is not named but is a member of a group to whom the proceeds are paid. One example of a class Beneficiary Designation would be "children of the insured."
Change of Plan Provision The Change of Plan Provision allows the policyowner to exchange the present policy for a different one. If the change is to a higher premium plan, such as exchanging an ordinary life policy for an endowment at age sixty-five, the policyowner must pay the difference in cash values between the two contracts plus interest at a stipulated rate. Since the net amount at risk is reduced, evidence of insurability is not required. Some insurers also allow the policyowner to change to a lower premium policy, such as exchanging an endowment contract for an ordinary life contract. The insurer refunds the difference in cash values to the policyowner. However, evidence of insurability is required since the net amount at risk is increased.
Life Insurance Policy Riders In life and health insurance the word "rider" is used in lieu of endorsement. The effect is the same in that riders modify the coverage of the basic policy the same as an endorsement would. The most commonly used riders in life insurance policies are:
§ Waiver of Premium. § Accidental Death and Dismemberment. § Guaranteed Purchase Option.
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Waiver of Premium This rider protects the insured in the event he becomes totally disabled. The waiting period usually is six months, and if the insured continues to be disabled after the six-month waiting period the premium payments on the policy will be waived. Many policies will also refund the premium that was paid by the insured during the six-month waiting period. The cost for this coverage is a bargain to say the least and no policy should be sold without this rider.
Accidental Death and Dismemberment The amount paid in the event of accidental death of the insured is usually the same as the policy's regular face amount. Therefore, if death occurs as the result of an accident the beneficiary receives twice the amount of the face value of the policy. Some agents may better recognize this benefit when it is referred to as "double indemnity." As a rule, the accidental death rider is very carefully worded to define exactly under what circumstances this benefit will be paid. The most liberal of the definitions is "accidental bodily injury." The less favorable wording would be that death must occur "by accidental means." For example, using "by accidental means" if an insured died from a broken neck after intentionally diving into the shallow end of a swimming pool the policy would not pay the accidental death benefit because the action of diving into this pool wasn't accidental. However, if the insured accidentally fell into the pool and drowned the benefit would be paid. Under the "accidental bodily injury" definition the intentional diving into the pool would have been paid. Normally, the death caused by the accident must consummate itself within 90 to 180 days of the incident. Under the dismemberment rider payment is made to the insured rather than the beneficiary. Benefits typically are paid for:
§ Loss of Sight. § Loss of Hand or Hands. § Loss of Foot or Feet.
Regarding the loss of hand or foot, the loss typically must involve "complete severance through or above the wrist or ankle joint." Loss caused by amputation is excluded unless medically necessary and as the result of an accidental injury.
Guaranteed Purchase Option This option is used most frequently with whole life insurance rather than term insurance. Under this option the company guarantees the insured that he or she may purchase additional amounts of coverage without evidence of insurability. These additional purchases usually are made at specific time intervals or events that change your family status. For example, some policies permit additional purchases of life insurance under the following circumstances:
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§ Every fourth policy anniversary year. § The insured purchases a new home. § The insured gets married. § The birth of a new child.
The premium charge for the additional coverage is typically based on:
§ The type of insurance purchased. § The insured's age at time of exercising option.
Accelerated Death Benefit This life insurance rider allows the insured to collect either all or a portion of their life insurance policy while they are alive. The insured can claim this rider if he/she is diagnosed with a terminal illness, requires long-term care or admission to a nursing home. With these conditions, the insured would most likely be unable to continue work and earn an income. This life insurance rider can help relieve some of the financial burden and medical costs.
Renewal Provision/Guaranteed Insurability Rider This life insurance rider guarantees your life insurance policy’s renewability at the end of its term (assuming you purchased a term life insurance policy rather than a permanent whole life insurance policy). Upon renewal, you can add coverage to your policy and will not need to provide further proof of your insurability. However, consult with your insurance agent to find out whether your provider grants this rider with conditions (does it expire after a certain age? Is renewability only valid within a set time period?). This life insurance rider is especially valuable because a term life policy may expire before the policyholder has passed on, but at a time when the policyholder’s condition is uninsurable.
Family Income Benefit Rider This life insurance rider provides a continuous monthly payment to your beneficiaries in the event of your death. Rather than receiving one lump sum, your beneficiaries can receive the death benefit in monthly payments, which means a reliable source of income. When adding this life insurance rider, the insured (you) chooses the length of the term you would like to provide this income security.
Long-Term Care Riders Most long-term care insurance is purchased as a stand-alone policy, but some companies that sell life insurance now offer riders that provide benefits if you need long-term care. In some states, insurers can combine traditional products like annuities and life insurance with other mechanisms designed to cover some or all of the cost of long-term care. This paves the way for insurers to offer life insurance products with "living benefits" that will help you pay expenses while you're still here. Fortunately, most states now permit the sale of long term care hybrid products. (And it's not just plain vanilla life insurance policies that offer long term care riders. Some variable annuities now
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offer long term care riders.) Riders for long term care are appearing on many types of policies, including disability and certain types of term insurance. You're probably familiar with the typical whole life or universal life insurance policy that offers a death benefit and a buildup in cash value. There are essentially two kinds of long-term care riders that are added to cash value life insurance: acceleration and extension riders. The acceleration rider lets you take "an advance" on your death benefit if long-term care becomes necessary. The rider makes it possible to accelerate payment of the death benefit in this situation. The death benefit in your life insurance policy is reduced by the amount used for long-term care expenses, along with a small service charge. If you need long-term care for a lengthy period of time, the death benefit will eventually be depleted. This same rider can be used when the insured has a terminal illness, which may require immediate payment of massive medical bills. Because accelerating the death benefit can have unfavorable tax consequences, consult with your tax advisor before exercising one. An extension rider increases your long-term care coverage beyond your death benefit. In fact, in certain situations, it can even allow you to keep drawing money for long-term care expenses, even after the death benefit amount in the life insurance policy is exhausted. These riders differ from company to company. With some, the policyholder collects a percentage of the death benefit each month. With others, long-term care expenses are reimbursed as they are incurred by you, up to the limit set by your rider. Before you can use any of these riders, though, something bad has to happen. Depending upon the rider you bought, needing home health care may entitle you to tap into the policy. Another rider may require you to be chronically ill and unable to perform at least two of the activities of daily living or suffer from a cognitive impairment such as Alzheimer's disease.
Nonforfeiture Options Life insurance policies contain nonforfeiture options. They are designed to give the insured ways in which he or she may gain continued value from a policy in the event the insured is unable to continue premium payments. The five nonforfeiture options are as follows:
1. Cash Surrender Value 2. Reduced Paid-Up Insurance. 3. Extended Term Insurance. 4. Automatic Loan Provision. 5. Dividend Accumulations to Avoid Lapse.
Cash Surrender Value A policyowner may surrender the policy and request that the company pay the cash surrender value of the policy, if any.
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As a rule, most policies have no cash value whatsoever for the first two to three years. The Cash Surrender Value usually consists of the following:
§ The policy cash value. § Cash value of paid up additions. § Dividends.
The Cash Surrender Value can be reduced by any outstanding policy loans and accrued loan interest on outstanding policy loans. It is important to know that all coverage ceases when the policy is cash surrendered. Payment is usually made in one lump sum and in some cases in accordance with one of the other policy settlement options already discussed.
Reduced Paid-Up Insurance Under this option the policyowner may request that the cash value of the policy be used to keep a reduced amount of paid-up insurance in force under the same policy. Usually the policy has a table contained in it that shows the amount of reduced insurance in any given year that the cash value that same year would purchase. Although the policy has had its face reduced the policy will continue to earn cash value and pay dividends if applicable.
Extended Term Insurance This option allows the same face amount of the policy to remain in effect for a specified number of years and days. As with reduced paid-up insurance, the policy will contain a table showing how long in years and days the original face amount will remain in force during any given surrender year. The length of time in years and days is calculated by taking the policy's cash surrender value, the insured's age and sex at the time premiums were discontinued and using that cash surrender value to purchase term insurance for a specified amount of years and days. Under this option the policy does not continue to earn cash value or pay dividends if applicable.
Automatic Premium Provision It is possible for the insured to authorize the insurance company to make an automatic loan from the policy's cash value to pay any premium not paid by the grace period.
Dividend Accumulations to Avoid Lapse Should the policy pay a dividend, then the dividend accumulations may be applied to any premium not paid by the end of the grace period. In the event the amount of accumulated dividends is not enough to pay the entire premium, coverage will then be extended in proportion
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with the amount of premium paid by the accumulated dividends. As a result of this a new grace period will start at the end of extension coverage.
Dividend Options If a life insurance contract is a participating policy that means that the policyowner is entitled to an annual dividend paid by the insurance carrier. Participating policies affords the policyowner the opportunity to participate in the earnings of the insurance company through dividend payments. The following are the ways in which a policyowner may use his or her dividends:
§ Cash Payment. § Reduction of Premium. § Accumulation at Interest. § Paid-up Additions. § One-year Term.
Cash Payment Under this dividend option the insurance company sends the insured a check equal to the amount of the declared dividend payment.
Reduction of Premium The premium due on the policy for the upcoming year will be reduced by the amount of the current year's declared dividend and the balance becomes the new premium due for the upcoming year.
Accumulation of Interest The dividend may be held by the insurance company to accumulate with interest paid at the rate that is specified in the contract. The insured has the right to withdraw the accumulated dividends at any time. Should the accumulated interest and dividend be on deposit with the company at the time of the insured's death, the accumulated interest and dividend will be paid along with the policy proceeds.
Paid-Up Additions This option enables the insured to receive additional amounts of life insurance by using the dividend to purchase paid-up additions. The additional insurance will be the same kind and subject to the same provisions as the original policy. Again, on the insured's death paid-up additions of insurance will be paid up along with the policy proceeds.
One-Year Term Some policies permit dividends to purchase one-year term coverage. The amount of the one-year term coverage would be added to the face amount of the base policy in the event of the insured's death.
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Settlement Options When benefits are paid following the death of the insured the payments of benefits is referred to as Settlement of the Policy. The following is an overview of the settlement options and then we will review them one at a time. They are:
§ Lump sum settlement. § Proceeds and interest. § Fixed years installments. § Life income. § Joint life income. § Fixed amount installments. § Other mutually agreed methods.
Lump Sum Settlement This is when the beneficiary receives the policy proceeds in a single payment following the death of the insured.
Proceeds and Interest Under this option, the insurance company will hold the policy proceeds and make interest payments to the beneficiary. The minimum interest rate is spelled out in the policy and the company may at its discretion to pay a higher rate. The beneficiary still has the right to withdraw all or part of the proceeds of the policy at any time.
Fixed Years Installments With this option, the insurance company pays the proceeds in equal monthly payments. The recipient of the proceeds chooses the number of years for which payments will be made. The amount received monthly depends on three factors:
§ Policy proceeds. § Number of years payments are to be made. § Interest rate paid by the insurance company.
Again, under this settlement option, the beneficiary still has the right to withdraw all or part of the proceeds at any time.
Life Income Under this settlement option, the beneficiary will receive equal monthly payments for the life of the beneficiary. The amount of monthly payments depends on four factors:
§ Policy proceeds.
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§ Beneficiary's sex. § Beneficiary's age at time payments begin. § Period certain for which payments are guaranteed.
Should payments be guaranteed for a period certain, such as ten years, payments will be made for the specified number of years regardless or whether the beneficiary lives to the end of that period. Should the beneficiary die during the period certain payments will continue to the beneficiary's designated successor.
Example: A beneficiary is going to receive $500.00 a month for 10 years certain. This means that should the beneficiary live the entire ten years he will receive $500.00 a month. After ten years there are no more benefits paid. However; if the beneficiary dies in the sixth year, the remaining four years of $500.00 per month will go to his designated successor.
Joint Life Income When this option is chosen equal monthly payments will be made so long as either one or two payees is alive. This option may be used when a policyowner insured contributes to the support of his or her parents. In the event of the insured's death, the parents, as beneficiaries, would receive monthly income for the rest of their lives. The amount of the monthly benefits would depend on two factors that are:
§ The policy proceeds. § Parents' ages at the time they begin to receive benefits. However; under this option,
the beneficiaries typically do not have the right to discontinue the monthly payments and receive the balance in a one-sum settlement.
Fixed Amount Installments Using this settlement option, the insurance company makes equal payments per month, or at longer intervals, in an amount chosen by the policyowner or beneficiary. All proceeds held by the insurance company will earn interest. If the monthly payment is greater than the monthly interest earned, the balance of the proceeds held by the insurance company decreases each month until the total proceeds and interest due are paid out. Under this option, the beneficiary may withdraw the unpaid balance at any time. If the beneficiary dies before the installments payments are completed, the unpaid balance is paid to the beneficiary's estate.
Other Mutually Agreed Method On occasion, a life insurance company may allow the policyowner to designate other payments methods if the insurance company agrees to them.
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An example of this may be that the proceeds at interest are to be paid to the insured's spouse for the spouse's lifetime and, upon the spouse's death, a one-sum settlement is to be made to the insured's children.
Premiums
Single and Periodic Premiums There are two basic ways to purchase a life insurance policy. The first is by paying the entire cost in one lump-sum payment. This is the "single premium" method. The second method of purchasing a policy is by the payment of periodic premiums. Rather than making a single payment for the insurance, the policyholder makes annual, semi-annual, or more frequent payments. A single premium policy is seldom purchased because of the large lump-sum payment that is generally required. The typical policyholder finds the periodic payments much easier to make. A second reason why single premium policies are seldom purchased concerns the cost of the policy if the insured dies in the early years of the contract. In this situation, the amount paid for the insurance under the periodic method will be less than the single premium amount.
Parts of the Premium There are three basic factors that affect the premium charged for a life insurance policy. The first is "mortality". Mortality refers to how many people within a given age group will die each year. The second factor is interest. Interest refers to the earnings the company receives on the premiums dollars it invests. The third factor is expenses. Expenses are, of course, all of the costs the company incurs in selling, issuing, and servicing its policies. As an individual grows older, the cost of insurance increases, since growing older increases the chance of death. Insurance companies use mortality tables and other statistics to determine the number of insureds, within each age group, who will die each year. What happens if more people died in a year than the company predicted? The company will pay out more for death claims than was anticipated. Another factor that influences the cost of insurance is the interest income that the company earns from its investments. Insurance companies receive millions of dollars each month in premium dollars. And, while each company has death claims and other expenses, the costs for these claims and expenses should be less than the total premiums received. By law, a life insurance company is permitted to invest this extra money to obtain additional revenue in the form of interest. Most life insurance companies invest in stocks, bonds, construction projects, and in a variety of other ventures designed to provide a return on their investment. The principal, as well as the interest earned, on these investments establishes a fund to pay all death claims as they occur and also helps to offset the cost of insurance. In addition to savings which may result from lower than anticipated mortality, an insurance company may also realize income from investments. Naturally, the insurance company is not
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permitted to keep all the money it receives. Expenses, of course, have to be paid. And, in addition to death claims, expenses include such items as:
§ Agent's commissions. § Salaries. § Advertising. § Physical examinations. § Legal costs. § Policy issue costs.
Here is a very simple formula that indicates how these factors affect premium costs: Death claims + other expenses - interest earned = premium to be charged. Keep in mind that no company determines the premium to be charged by the simple method we have described above. This simplified approach merely describes the important relationship between these factors.
Net and Gross Premium The premium that a company charges for a life insurance policy is called the "gross" premium. When a company is calculating the premium for a policy, it begins by determining the "net" premium. Once the net premium has been computed, the company then adds the expense factor, or "loading", to this net premium to arrive at the gross premium.
Mortality and Interest Factors Two basic factors go into the calculation of the net premium—the mortality and interest factors. An insurance company cannot predict when a particular insured will die. However, by using the mathematical concept of probability, the company can predict, with a great deal of accuracy, the number of insureds that will die each year. This prediction of future mortality is made on the basis of past mortality experience and assumes that future experience will parallel past experience. But, if past mortality is to be a reliable basis for prediction, accurate data must be kept on a large group of representative individuals for a sufficiently long period of time. Information on past mortality is analyzed and arranged in a table, called the "mortality table" which shows probable death or mortality rate at a specific age. Beginning with a given number of individuals at a given age, the mortality table shows the number of people out of the group who probably will die at each age and the number who will survive. Even if the mortality rates and the mortality table are accurate, a company that wants a reliable estimate of future mortality must apply the rates to a large enough group of individuals for the "law of averages" to operate.
Level Premium Concept Reserves Once the net single premiums are computed, the company then converts that premium into a "net level premium" since few policies are purchased by the single premium method.
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The early renewable term premium, also called a "natural or step-rate" premium, increases each year as the insured ages and the risks of mortality increases. The premium rises rather gradually during the younger ages, but increases sharply for the older ages. As a result, the premiums can become prohibitively expensive for most insureds at the older ages. To overcome the problem of annually increasing premiums, companies develop the level premium plan. With this plan, the premium remains the same during the premium payment period rather than increasing as the probability of death increases. This level premium is higher than the natural, or yearly renewable term; premium in the early years of the policy but is lower than the natural premium in the later years. Under the natural premium plan, the net premium charged policyowners each year is just sufficient to pay the expected claims for the year. This is not true for the level premium plan. The net level premium payments made in the early years of the contract are greater than the amount needed to pay the policy claims during those years. By investing the excess part of the premium in the early years, the company accumulates funds to cover the deficiency that occurs in the latter years. These funds, which the company holds to meet future policy obligations, constitute the policy reserve or simply the "reserve". The reserve is the amount that, together with future premiums and interest earnings, will be sufficient for the company to pay all future policy claims, based on the company's mortality and interest assumptions. Thus, the reserve is a liability - future obligation to the company. Because a company's ability to fulfill its contract obligations depends upon sufficient policy reserves, the state requires a company to maintain certain minimum reserves. Most states now require that the insurance company become part of the legal reserve pool. State laws specify the mortality table and the assumed rate of interest to be used in calculation of the legal minimum reserves. Because of these state regulations, reserves are often called "legal reserves".
Insurance Age Premiums charged for life insurance depend upon the insured's age. The mortality factor is one of the three basic elements of the premium and the mortality factor varies with an insured’s age. However, the age used to determine the premium is the insured's insurance age. The insured's insurance age may, or may not, be the same as his actual or chronological age. A company may use one of two methods of determining an insurance age. In the first method, an insured's insurance age is his age at the insured's nearest birthday. If the insured turned age 30 less than 6 months ago, the insured's age would be 30. However, if the insured's 30th birthday was more than 6 months ago, the insurance age would be 31 since the next birthday would be nearer than the last. Although the nearest birthday is the more commonly used method, some companies may use the insured's last birthday to determine the insurance age. The insurance age under this method is the
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same as the insured's actual age, regardless of the number of months since his or her last birthday.
Tax Treatment of Life Insurance The U.S. Government has recognized that it is good public policy to encourage the sale of life insurance for the protection of families in the event a provider dies prematurely.
The Role of Insurance Programs By now you know that there are many personal and business financial needs that can be satisfied through the implementation of an insurance program. Quite simply, life insurance and annuities play an integral role in providing financial security. The federal government recognizes this. It is also aware of its responsibility to encourage people to provide for their own financial security to promote personal savings and to preserve businesses. In short, the federal government has an obligation to discourage its citizens from relying on others to provide for their own financial integrity. There are few devices available to the government to accomplish these goals. Americans, being pragmatic in many ways, do not always react overwhelmingly to personal appeals by the government (except, of course, in times of national emergency). However, they do respond to tax-savings opportunities, and control of taxation is one of the most powerful controls the government can exercise. Our federal government long ago recognized that life insurance and annuities play an important role in instilling a sense of personal financial responsibility and security in American society, and providing tax-saving incentives to these products is the most practical means of encouraging their use.
Favorable Tax Treatment Life insurance and annuities receive favorable tax treatment.
Tax Treatment of Premiums Premiums paid for life insurance are a personal expense and are not tax-deductible (IRC 101-a-1). There are some exceptions to this rule when the premiums are used in a qualified retirement plan. Exceptions also exist when the premiums are paid pursuant to a divorce decree (they may then be deducted as alimony payments) or when the premiums are used to fund a life insurance policy owned by a charitable organization.
Tax Treatment of Cash Value Accumulation The growth of a life policy cash value accumulates on a tax-free basis. The only exception to this rule is where the cash value exceeds the total sum of premiums paid (which is called the policy-owner's cost basis), and, even then, taxes are payable only on the excess portion of the cash value and only when the cash value is actually received. In a participating policy, dividends are generally nontaxable. They are considered to be a return of excess premiums and are not taxable as long as the premiums were paid with after-tax dollars.
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Tax Treatment of Death Benefits - Proceeds of Life Insurance - Not Taxable When an insured dies and the proceeds are paid to a beneficiary lump-sum, the funds are not subject to income taxes. If the proceeds are held by the company and paid out in installments, the interest is taxable; the original death benefit is not. Dividends left to accumulate with interest will have the interest taxed, not the original dividend. When there is a Transfer of Benefits in the proceeds to life insurance for a valuable consideration, the death proceeds lose their income tax exempt status. Internal Revenue Code Section 101(a) generally excludes from the beneficiary's gross income the proceeds paid from a life insurance policy. This is perhaps the most significant tax advantage of life insurance. It allows a person to provide for the economic security of a spouse or business associate after the death of the insured without fear that the proceeds are going to create an income tax liability for the beneficiary. The amount of the death benefit specified in the policy is received free of income tax liability. However, there are some exceptions. Basically, any settlement option that provides for a periodic payment of benefits will result in taxable income but only to the extent that part of each payment represents additional interest paid by the insurer. Let's look at an example to clarify this. Suppose a beneficiary, entitled to a life insurance benefit, decides to elect the fixed period option. For the sake of discussion, we'll assume that each monthly payment will be in the amount of $200, of which $150 is a return of the policy benefit and $50 is interest paid by the insurer on the amount still being held by the insurer. In this example, $50 represents taxable income to the beneficiary.
Tax Consequences of a Policy Surrender As mentioned above, life insurance cash values are not taxable income as long as they do not exceed the sum of all premiums paid by the insured (the insured's cost basis). The value of any cash value in excess of the cost basis represents taxable income.
Tax Treatment of Policy Loans The right to make policy loans is an important feature of any whole life policy. The availability of loans against the cash value has helped countless policyowners meet financial objectives. When a policy loan is made by the insurer, it is done so with interest. Income tax deductions for interest paid on personal debt (except personal residence debt) are no longer deductible.
Premiums that are not deductible Almost all premiums for life insurance are not deductible.
Personal Life Insurance Premiums which are deductible:
§ Business life insurance purchased on a key employee § Premiums paid for life insurance owned by a qualified charity.
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§ Premiums paid by an ex-husband as part of court ordered alimony. § Premiums paid by a creditor to secure a debt. § The employer under certain conditions can deduct group term life insurance paid
by an employer. The employer must not be the beneficiary of the insurance.
Life Insurance and Estate Taxes Upon an insured's death, the amount of life insurance is part of the insured's gross estate for federal estate tax purposes. The proceeds are not subject to federal income taxes, however.
Third-Party Ownership of Life Insurance When someone other than the insured owns life insurance, it is called Third-Party ownership. The insured and insurance company are the first two parties. This could be a Juvenile policy, a corporation taking out a life insurance policy on their president, or a husband making his wife the owner of the policy that insures his life. The husband would be keeping the life insurance out of his estate for a possible estate tax savings. Third-Party ownership may be established when the insurance is applied for or may be accomplished at a later time by assignment.
Transfer of Value Rule Life insurance proceeds are usually paid to the beneficiary income tax free. One exception to this is the transfer of value rule. If person A sells their life insurance policy to person B for $2,000 and person B agrees to pay the premiums, upon the death of person A, person B would receive only the $2,000 and the amount of premiums B paid income tax free. The remaining death benefit would be taxable.
Modified Endowment Contract (MEC) Modified Endowment Contracts are Whole Life policies (or annuities) that have been penalized by the Internal Revenue Code, since1988, because they accumulate cash values too quickly within the first seven (7) years they are in effect.
7 Years The first seven (7) years of cash accumulations determines whether or not the policy is, in fact, a MEC rather than a regular whole life policy. The IRS calls this, the "seven pay test.”
Forever If the IRS considers a policy a MEC, it will be considered one "forever." Whenever a MEC is cash surrendered, the penalty is ten (10) percent.
No Penalty to Beneficiary One-way for the insured to escape the tax and the penalty are to die. The beneficiary would receive the face amount of the policy without any taxes or penalty being due.
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Chapter 3 Objectives Upon completion of this section, you will:
§ Gain increased awareness of life insurance needs and uses. § Discover how utilization of life insurance applies to charitable and business situations.
Chapter 3 Life Insurance Needs and Uses
Insurance Needs At this point we have looked at the types of life insurance and how life insurance is regulated. There is another important area to be examined: we must look at how to identify an insurance need, how to select the best product to meet that need, and how personal insurance needs differ from business insurance needs. In this lesson, we will also look at the federal tax treatment of life insurance.
Identifying Life Insurance Needs
Insurance Needs We know that life insurance has an important role to play in solving financial needs brought on by death and that it has certain living benefits as well. But how much insurance — and what type of insurance — is appropriate for someone? Developing the skills to answer this question for your clients will be one of the most important responsibilities of your insurance sales career. It is simply not correct to suggest that someone should purchase as much insurance as he or she can afford; this can result in being underinsured in some instances and over insured in others. Formulas will guide you in helping your clients determine their insurance needs. There are two general methods used to identify insurance needs today. Both attempt to place a dollar value on the amount of money needed at death to meet certain objectives.
Human Life Value The human life value approach has been associated with determining life insurance needs for nearly 100 years, but it was not formally embraced as a method of identifying needs until early in the 1920s. The late Dr. S. S. Heubner, a noted insurance educator at the University of Pennsylvania's Wharton School, is credited with popularizing this method. The human life value concept is based on the premise that life insurance is intended to substitute for the insured as an income producer upon the death of the insured. In short, this method
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attempts to determine the present value of future income that would be lost if the insured died prematurely. The amount of life insurance needed is equal to the present value of lost future earnings. A simple example will help illustrate this concept. Let's say an individual earns $50,000 per year and has 25 years left to retirement. That person can expect to earn $1.25 million prior to retirement. Of course, someone earning $50,000 annually does not need a $1.25 million life insurance policy. For one thing, many of that individual's personal expenses will cease at death. It must also be assumed that money set aside today will earn interest, reducing the amount of money needed today. By reducing the potential future earnings by personal living expenses (including taxes and insurance premiums) and further discounting the amount by a reasonable interest assumption, a more realistic life insurance need is calculated. In our example, the amount could easily drop to $150,000. The human life value approach is commonly used in lawsuits where a jury is asked to award a large sum of money to compensate for the wrongful death or serious injury of the plaintiff.
Financial Needs Approach A more common method of calculating the amount of life insurance needed is to look at all the financial needs of the insured's family or business. Examples of expenses that should be considered include:
§ Final Expenses. This includes not only funeral and burial expenses, but estate tax expenses as well.
§ Income. Will the surviving spouse be able to pick up the slack of the deceased's lost earnings? In most cases this will not be possible, and life insurance can, of course, play an important role. Social Security Survivors Benefits will help in this area, but almost certainly not to the full extent needed.
§ Housing. Does the insured want the family's home mortgage paid off? The value of the remaining mortgage should be considered in calculating the client's financial needs.
§ Education. If there are young children in the family, the future costs of education are an important consideration.
Permanent insurance can provide living benefits, through its cash values, that can figure prominently in planning for future financial needs. For the insured who lives to retirement, life insurance can play an important role in the following areas:
§ Retirement Income. A policy's cash value can offer an important supplement to any other retirement and social security benefits to which the insured may be entitled.
§ Emergency Fund. Countless families and businesses have been spared financial disruption because of the availability of a life insurance cash value loan to meet an unexpected financial emergency.
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Uses of Life Insurance
Personal Uses Certainly, the most important use of life insurance is to meet the financial needs that accompany a person's death, especially an untimely death. Life insurance also offers certain living benefits, as we have just discussed. Life insurance is recognized as an important investment tool. Not only does it generate a cash value on a tax-free basis, but it can substantially increase in value upon the death of the insured. It is said that life insurance is the easiest way to create an estate. It's not difficult to see how. Consider the client who takes out a $100,000 policy. If that person suffers a premature death after making as little as one premium payment, it's obvious that a tremendous increase in the value of that investment (the premium payment) will be realized and that the deceased will have instantly created a sizeable estate for his or her family. No one enjoys thinking of the possibility of dying prematurely, but the responsible individual recognizes that it happens every day. The existence of a meaningful life insurance program can create peace of mind that is difficult to measure but that is very valuable nonetheless.
Charitable Uses An important personal use of life insurance is in charitable giving. Many people have favorite causes to which they would like to contribute, but find it difficult under present financial circumstances. The use of life insurance can play an important role in helping these people. Consider the following advantages of using life insurance in making a charitable contribution:
§ For a relatively small periodic outlay, a person can assure his or her favorite charity that a significant contribution will be forthcoming upon the donor's death.
§ If the charity is made the policyowner, the donor may be entitled to deduct premium payments from his or her taxable income as a charitable contribution.
§ By letting the life insurance policy make the contribution, it probably will be greater (due to the possibility that the death benefit will greatly exceed the amount of premiums paid) and will be made quickly by the insurer without having to go through probate.
Business Uses There are some important uses of life insurance in the business world. Let's look at them in closer detail.
Buy-Sell Agreements Sole proprietorships, partnerships, and close corporations face troubling financial consequences upon the death of an owner.
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With a sole proprietorship, where the business is owned by one person, the death of that owner would mean the end of the business unless someone steps in and assumes ownership. Of course, the owner may pass it on as a gift to a family member — if one is available. Often the owner will want the business to be continued under the control of a loyal and competent employee. While the owner may gift the business, such a step would be unfair to the owner's family. The best approach is to make funds available for the employee to purchase the business from the deceased owner's estate. A buy-sell plan, drafted by an attorney and funded by life insurance, is established for this purpose. Under a sole proprietorship buy-sell plan, the employee is the owner and beneficiary of the policy. When the owner dies, the policy proceeds are used to purchase the business from the estate of the deceased owner. As a result, the business is continued by a competent person and the family receives fair compensation for the sale of the business.
The Entity Purchase Buy-Sell Agreement The business entity (partnership or corporation) buys life insurance on partners or stockholders so that the entity can purchase the share of business owned by a deceased partner or stockholder.
The Cross Purchase Buy-Sell Agreement The owners agree to a Buy-Sell contract drafted by an attorney so that, when a partner dies, the survivors can purchase the deceased partner's share of the business. The purchase is often financed through life insurance. The value of the business must be determined (and periodically reviewed) and each partner buys life insurance on the other partner's lives. If there are three partners and the business is valued at $300,000, each partner will purchase a $50,000 policy on each of the other partners. If there are three partners, a total of six policies will be needed to finance the agreement. To figure the number of policies needed, subtract one from the total number of partners and multiply that number by the original number. Three partners equal six policies, four partners equals twelve, etc. Each partner is both the beneficiary and the owner of the policies he or she purchases on the other partners.
Key-Employee Life Life insurance is purchased on a valuable employee and, in case of death; the company receives the death benefit of the life insurance to compensate them for their loss. The premiums are not tax-deductible to the company and the company is not liable for taxes on the death proceeds they receive. Death of a key employee in the company will have adverse consequences. In smaller companies, especially the death of a key employee can be very disruptive to the flow of business. A key employee is anyone whose role in the company is essential to its success — this is usually someone at the executive level. Key-employee insurance is intended to indemnify a business for the economic hardship brought on by the death of a key employee. How a company defines economic loss is somewhat subjective. A common method of determining the amount of insurance needed is to estimate the loss of company profits that would result until a suitable replacement could be found. Any
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bonuses which might have to be paid to attract the right person would also be considered in calculating the amount of life insurance protection needed. Key-employee life insurance policies are owned and paid for by the business organization, which is also the beneficiary.
Section 303 Redemption The IRS allows a corporation to purchase part of the stock from an owner's estate to help pay death taxes and funeral expenses. This can be funded by life insurance.
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Unit TWO Disability Income
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Course Description Course Overview and Objectives
This section explores and details the different types of products and situations disability income along with its many uses when it comes to providing for individual, family, and business needs. The disability income component in this course is designed to review and teach you about the features of the various types of disability insurance options and non-insurance specific programs, as well. The course explores individual disability insurance, employer-provided disability insurance, government programs that pay disability benefits, and the taxes inherent on these benefits. Provided also is a discussion of the specialized disability-related policies that are used for overhead expenses and buy-sell agreements. Association and Salary continuation arrangements with group disability income protection programs are discussed, as well.
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Chapter 1 Objectives Upon completion of this section, you will:
§ Gain increased awareness of disability income fundamentals. § Be better informed about Social Security and Workers Compensation issues. § Discover what to expect when applying for disability income protection coverage.
Chapter 1 Disability Income
Disability Income Fundamentals
Introduction Could you continue to take care of your family and pay your bills if you were sick or injured and unable to work for any length of time? Do you know how much money would be coming in each month—and from where—if you were to become disabled? Not everyone is covered for disability income. Some can rely on their employer's group disability coverage. Others are covered by government disability programs. But, for many people, an illness or injury that stops their paychecks would create problems for them and their families.
Disability Income Insurance Can Help It is designed to replace a major portion of income when sickness or injury prevents a person from earning a living. It can help pay regular monthly bills while a person is recovering, but is still unable to do his or her job. This chapter explains a number of important things:
§ The chances of becoming disabled § How it can affect finances § Possible sources of disability income § What disability income insurance is § What disability income insurance covers
This chapter also helps us think about how much income we or our clients would need if we became disabled and were unable to work, and possible sources of disability income. It also includes a checklist to help us and them compare disability income insurance policies.
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Disability Is Likely to Prevent Us From Working According to the National Association of Insurance Commissioners (NAIC): A male U.S. worker at age 35 faces a one-in-five chance of a disability taking him off his job for 90 days or longer. Before a 35-year-old woman reaches retirement age, she faces a nearly one-in-three risk of a disability lasting at least 90 days. The risk of a long-term disability during a worker's career is greater than the risk of premature death. Yet most workers would never think of going without life insurance protection for their families.
What Disability Means Financially for Us and Our Family It can take a huge toll on our finances. A lengthy disability that takes away the main source of income can be devastating to a worker and his or her family. It reduces income while adding large expenses, such as the need for help with everyday activities. For example, a 45-year-old worker making $50,000 who suffers permanent disability stands to lose $1,000,000 in future earnings. He or she would also be unable to continue building retirement savings. Savings often aren't large enough to help. Savings can play a key part in meeting financial needs during a disability. But most workers' savings would only help their families through a few months.
Disability Income Insurance It is insurance that provides you with income if you ever become disabled. It helps protect against family financial disaster by providing income to meet every day needs during a disability. It comes in three main forms:
Government-sponsored programs
These include workers' compensation and the Social Security Disability Insurance (SSDI) program.
Private employer-sponsored group disability plans This coverage is an important benefit for many employees. It provides income replacement that enables employees who are disabled to pay bills and maintain their lifestyle. Employers may sponsor short- or long-term disability coverage, or a combination of both. The employer often pays for all, or part, of the premiums for the coverage.
Private individual disability income policies
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Individuals pay for these policies. They guarantee income when there isn't enough employer- or government-sponsored coverage.
When You are Covered by Group Disability Benefits First, be aware of the difference between short-term and long-term disability insurance.
Short-term Many employers provide disability income benefits under a short-term disability plan, which may provide benefits for as long as six months. Coverage periods vary. Some state laws require most employers to provide temporary disability income benefits for up to 26, 30, or even 52 weeks.
Long-term No state or federal laws require employers to offer coverage for long-term disability, typically defined as lasting for more than six months. But the Bureau of Labor Statistics, U.S. Department of Labor, indicated that in 2016 nearly one in three U.S. workers were offered employer- sponsored group long-term disability (LTD) coverage. Generally, employer-sponsored group long-term disability plans replace about 60% of base salary (usually, bonuses are not included). Long-term disability starts when short-term disability benefits have run out, and continue anywhere from five years to age 65. Often, group long-term disability insurance coverage is fully paid for by employers without any payments being made by employees. Next, find out exactly what benefits your employer offers in the event of a disabling illness or injury. Check with your employer to see if you have disability income coverage. If you do, find out:
§ What benefits would be available to you § How long after the start of a disability you would have to wait before benefits
begin § How long payments would continue § If your employer's plan takes other disability coverage (such as government
programs) into account § If your long-term disability benefit is subject to a maximum amount you can
receive § Ask for a booklet describing the disability coverage your company offers.
Would You Qualify for Social Security Disability Insurance (SSDI) Benefits?
Social Security Disability Insurance Most workers in the United States participate in the federal government's Social Security program. Social Security (SS) is best known for its retirement benefits. The Social Security Administration also administers the Social Security Disability Insurance (SSDI) program. The SSDI program provides benefits for disability—not for retirement.
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Find out if you would qualify for SSDI if you were ever to become disabled. Contact your local Social Security Administration office to find out if you would qualify for SSDI if you were to become disabled. They can help you estimate the disability benefits you would get. You can go to the agency's website at www.ssa.gov to find a disability benefit calculator and other SSDI program information.
Know what to expect: If you qualify for SSDI benefits, your income and work history determine the amount of your SSDI benefits.
Be aware of what some people get Recently, there were more than 10 million SSDI recipients. This includes eligible spouses and children of disabled workers. The average monthly SSDI benefit is just over $1,000. SSDI benefits can be an important source of income should we suffer a disabling illness or injury. Bear in mind some important points:
§ It can be difficult to qualify for SSDI benefits. To qualify for SSDI benefits, a disabled worker needs to prove that he or she cannot perform work that earns any significant amount of money. Disabled workers are eligible for SSDI benefits only if a disability is expected to last for at least 12 months or result in death.
§ The time it takes the Social Security Administration to approve an SSDI claim
often delays benefits for months—or years in some cases.
§ Disability income payments made under other government programs may reduce SSDI payments. Why? Because the total combined payments from Social Security, workers' compensation, civil service, and military programs generally cannot be more than 80% of your average pre-disability earnings.
§ SSDI payments can be subject to federal income tax. This is the case when your
"combined income" (adjusted gross income plus any nontaxable interest income and half of your benefits) is more than a certain amount.
SSDI benefits often are not enough to maintain an average lifestyle for those who do qualify. In fact, relying on SSDI benefits alone would leave many families at or below poverty, as defined by the U.S. Department of Health and Human Services Federal Poverty Level.
What Does Workers' Compensation Cover? All states require employers to provide workers' compensation coverage to most workers. Under these programs, workers who become injured or sick on the job are eligible for limited disability income benefits. Typically, these payments are equal to two-thirds of pre-disability income, within various state limits.
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Workers' compensation, however, does not provide disability income for those whose injuries or illnesses are not job-related. Most people who become disabled are not eligible for workers' compensation.
Disability Income from Other Sources? There are a number of other possible sources of income if you become disabled. The availability and extent of these and other programs vary widely. But, one or more may be an important source of income should you become disabled. For veterans: Veterans Administration pension disability benefits for eligible veterans For civil servants: Civil service disability pay for federal or state government workers For miners: Black lung program for miners For union members: Group union disability coverage For low-income citizens: Supplemental Security Income (SSI) for those with low incomes and limited assets For people in debt Private insurance, such as credit disability insurance, that makes monthly loan payments when you are disabled Vocational rehabilitation: State occupational rehabilitation programs Automobile: Automobile insurance, if your disability results from an auto accident Your own savings: Of course, your own resources, such as a savings account, can be another important source of disability income Find out if you are eligible for any of the above. If you are, find out how long benefits will be paid. If you have savings, figure out how long they will last.
How Much Disability Income Will You Need? Here's how to find out: Calculate your benefits. Add up all the income you may be entitled to under the public and private programs listed. Calculate your savings. Add up the monthly income you could include from other sources, such as your personal savings. Add them up. If the total income approaches the income you need after taxes, you can assume that, should total disability strike, you would be able to pay your day-to-day bills while getting better. Then, think about added expenses. A disabled individual may face increased health care costs. He or she might also need extra money to pay for help with shopping, housework, yard work, cooking, or transportation. Funds may also be needed to make the home disabled-accessible by adding ramps and widening doorways. Decide if you need additional income. The total from employer benefits, Social Security, and other programs, along with your own resources, may not be close to your pre-disability, after-tax
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income. It may not be enough to support your family. If it is not enough, you will want to consider buying more disability income insurance to make up the difference. Be aware that some things may reduce your disability income benefits. Social Security or Other Government Benefits. The amount of long-term disability benefits you may collect may be reduced by the amount received from Social Security or other government programs. This is true whether you are covered through your employer's group plan or through your personal insurance benefits. Taxes. Although disability income benefits are tax- free when an individual has paid the policy premiums, disability income benefits are taxable when received from a policy an employer has paid for. These facts must be taken into account when you are trying to figure out your disability income needs. Think about your work situation.
§ If you are an employer, consider a group policy for you and your employees. § If you are self-employed, an individual policy is a good idea. § If you work for a business that does not provide benefits under a group policy, an
individual policy is also a good idea. Consider using an agent. Whether you are an employee or an employer, an insurance agent can help you analyze your sources of disability income, determine how long it will take to receive various benefits, and determine whether additional coverage would be wise.
What to Look for in a Policy Your client may find that they need an individual disability income policy over and above any other income protection they may have. Here's what they need you to look for:
Definition of Disability Be sure to determine how various policies define disability. Policies vary. Some pay benefits if one can't do their regular job. Others pay only if they can't work at all.
Extent of Disability (Total or Partial) Some older policies require that you be totally disabled before payments begin. Partial disability sometimes is covered for a limited time. But, most often, partial disability is covered only if it follows a period of total disability from the same cause. Some policies may not require total disability before partial disability payments are made.
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Residual Benefits A residual benefit allows partial payment based on your loss of income. For example, suppose you were able to work, but your income is reduced because you cannot fulfill all of your job responsibilities. In this case, residual benefits can help to make up the difference in your income. Residual benefits can generally be paid without total prior disability. It is a standard feature in some policies. But, in other policies, it is a feature that is added to the policy with a rider for an additional premium.
Presumptive Disability Under some policies, you may be presumed to be fully disabled and entitled to full benefits, even if you can still perform some or all of your regular job duties. This can happen under certain conditions, such as losing your sight, speech, hearing, or use of your limbs. In these cases, the "elimination" period is generally waived. A plan's elimination period is the length of time between when the disability begins and the point at which the payment of disability benefits starts.
Amount of Benefits Monthly benefits are generally calculated as a percentage of your stable, earned income at the time you buy the policy. A typical disability insurance benefit is 60% of pre- disability income. Disability income insurance policies generally require that disability payments from all sources cannot approach or exceed pre-disability income. So the amount of benefits paid by a disability income policy may be reduced when a disabled worker is getting disability payments from other sources, such as workers' compensation or the SSDI program.
When Payments Begin Many policies allow you to decide when benefit payments begin. You can choose a waiting period at the time of application. The waiting period may range anywhere from 30 days to 180 days, or more, after the disability begins. Depending on how much money you have saved, and your other resources, you can reduce the amount you pay for your policy by electing to wait 60 days, 90 days, or even 180 days before you would start to receive benefit payments. Remember, though, that the first benefit check is usually not paid until 30 days after the waiting period. Length of Coverage When you choose a "benefit term," you are choosing how long benefits are payable to you: for one year, two years, five years, or to retirement age. Since disability benefits are designed to replace the income you would otherwise earn by working, most people do not choose benefits extending beyond their working years.
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A lengthy disability threatens your financial security much more than a short-term disability. Choosing shorter benefit periods can save you dollars on the policy itself. Bear in mind that if you need this insurance at all, you probably would need it most to cover a disability that permanently removes you from the workforce. Keeping Pace with Inflation For an additional premium, you may be able to add a cost-of-living adjustment (COLA) to basic disability income coverage. This provision increases the benefit payout by a specific percentage, after each year of disability. Generally, the increase is from 4% to 10%. This can be important, particularly during a lengthy period of total disability. Some policies offer the opportunity to buy additional disability coverage to keep pace with a rising income, without having to undergo a medical examination or to provide further medical evidence that you are still insurable. Waiver of Premium Most policies include a "waiver of premium" provision so that you don't have to pay any more money on the disability policy after you're disabled for 90 days and until your disability ends. Non-Cancelable Versus Guaranteed Renewable Selecting the kind and length of benefits is only the first step. You should also ask about your choices for keeping your disability policy in force. Most disability income insurance comes with one of two types of renewal options:
§ Non-cancelable policies give you the right to continue a policy by paying the premiums on time. In this case, the insurance company cannot change the premiums and benefits shown in the policy.
§ Guaranteed renewable policies will be automatically renewed with the same benefits. The premium, however, may go up if it is changed for everyone who has the same insurance policy from the company.
While most individually purchased disability income policies are either non-cancelable or guaranteed renewable, other kinds do exist. Conditionally renewable policies can be canceled by class or geographic area, or for reasons stated in the policy other than deterioration of health. Optionally renewable or conditionally renewable policies are extended at each anniversary or premium due date if the insurance company decides to do so. Some policies are renewable to age 75 if you are still employed full time.
What the Policy Does and Does Not Cover Consider carefully the kind of protection that is best for you and your family. Some policies pay for disability arising from accidents, but not illnesses. Illnesses, however, are a frequent cause of disability. In fact, as you get older, it is more likely that you will need disability coverage for an illness than for an injury.
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What to Expect When Applying for Coverage When someone applies for individual disability income coverage, the insurance agent or insurance company will require the person to provide information including general information, medical history, income, and employment. General information includes name, address, sex, age, Social Security number, and citizenship status. This information is used to verify your identity; to permit access to important sources of financial information; and to provide information that the company needs to issue an insurance plan. Employment information enables the insurance company to understand your occupation and work duties. Full and accurate disclosure is extremely important. You should, for instance, provide information on both full- and part-time jobs. Medical history information includes information about any illnesses, accidents, or treatments you may have had, and whether you have had certain medical tests within the past few years. Occasionally, your application for individual disability income insurance may require one or more medical tests—such as an EKG. You will also likely be asked for blood testing, including a test for exposure to HIV (the virus that causes AIDS). The insurance company must handle these tests and test results in a way that keeps them confidential. Financial information is necessary for an individual disability income insurance application so that the insurance company understands the income that is to be insured. The insurance company will ask you for information about wages, salary, and other compensation. Self-employed applicants are asked to provide information about net earnings. Information about other income, such as dividends, interest, and rents, must also be provided. It is very likely that you will be asked to provide copies of income tax returns. The insurer must treat all such financial information confidentially.
What Else Do You Need to Know?
Tax Considerations In general, if you pay the premiums for an individual disability policy, payments you receive under the policy are not subject to income tax. If your employer paid some or all of the premiums, some or all of the benefits may be taxable.
Business Protection for Small Business Owners Disability insurance is particularly important if you own a small business. In addition to standard disability income replacement, business protection is also available. There are recovery benefits that pay after you return to work full time. These apply during the period in which you are re-establishing a customer or client base. There is overhead expense coverage that pays for certain office expenses. For jointly owned businesses, there is a disability buy-out policy that provides funds for one partner (or the business entity) to buy a disabled partner's share of the business. And there is key-
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person insurance. This protects a firm against the loss of income resulting from the disability of a key employee. This is discussed fully in another chapter in your course.
Disability Insurance Policy Checklist Every policy may have different features. The following checklist will help you and your clients compare policies you may be considering:
§ How is disability defined? Is it defined as the inability to perform your own job, or inability to do any job?
§ Does the policy only cover disability from accidents, or both accidents and illness? § Are benefits available for partial or residual disability, as well as for total disability? § Are full benefits paid, whether or not you are able to work, for loss of sight, loss of
hearing, or loss of limbs? § The maximum benefit will replace what percentage of income? § Is the policy non-cancelable, guaranteed renewable, or conditionally renewable? § How long must you be disabled before premiums are waived? § Is there an option to buy additional coverage, without undergoing additional medical
tests or examinations, at a later date? § Does the policy offer an inflation adjustment feature? If so, what is the rate of
inflation? Is there a maximum? Your clients will probably ask you about the following:
§ What is an adequate level of benefits, in relation to your present and future obligations?
§ How long a waiting period (until benefits begin) should you select to fit your situation?
§ How long do you want to receive disability income should it become necessary? § How much coverage can you get at your present salary?
Final Note These are recommendations for purchasers of Disability Income insurance. You should know in advance what you would say and provide to respond professionally to these questions and requests by your prospects and clients. Read the policy itself before you buy. Insurance policies are legal contracts. Read and compare the policies you are considering before you buy one, and make sure you understand all of the provisions. Marketing or sales literature is no substitute for the actual policy. Ask for the insurance company's ratings. The A.M. Best Company, Standard & Poor's Corporation, and Moody's all rate insurance companies after analyzing their financial records.
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Ask for a summary of each policy's benefits that outlines the coverage. Good agents and good insurance companies want you to know what you are buying. Don't be afraid to ask your insurance agent to explain anything that is unclear. If you are not satisfied with an agent's answers, ask for someone to contact within the company. Be aware that you have some time to return your policy. Even after you buy a policy, if you find that it doesn't meet your needs, you generally have 10 to 30 days (this varies by company and state) to return the policy and get your money back. Find out how to contact your state's department of insurance. You should know that every state has a department of insurance that regulates insurers and helps consumers. If you need more information, or if you want to register a complaint, check the government listings in your local phone book for your state's department of insurance.
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Chapter 2 Objectives Upon completion of this section, you will:
§ Gain increased awareness of group and short-term disability income purpose. § Gain increased knowledge of group and short-term disability income definitions and
features. § Know more about riders available and how they can benefit a client’s unique needs.
Chapter 2 Group Long-Term and Short-Term Disability
Income
Three Principal Contingencies
Death, Retirement, and Disability Most individuals and their dependents rely solely upon current earnings for their maintenance. In the event that these earnings are reduced or cut off entirely due to a major contingency (i.e. disability), this individual and his or her family will be faced with serious economic problems. The three principal contingencies common to all people involve premature death, retirement, and last but not least, disability. Although Picasso continued to paint well into his 90s and may not have been disabled during his lifetime, for the most part, no individual is able to escape all three major contingencies. Let us take a brief look at each one of these contingencies. Generally speaking, death is unpredictable. The economic loss which results from an individual's premature death has received a great amount of attention over the last several decades. Hence, the evolution of individual and group life insurance and other types of death benefits (i.e., accidental death benefits). An individual's retirement is a more defined and predictable contingency than that of one's premature death. In most cases, it occurs at the end of one's working career and there is usually time to provide for it. Like premature death, a disability is also unpredictable. Statistics abound which demonstrate that disability is more likely to occur during an individual's normal working career than premature death. The economic hardship caused by one's premature death has always been viewed as paramount. However, disability for an extended period of time may produce even greater economic hardships to an individual's family than his or her death would. This is due to the fact
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that his or her own living expenses, as well as those of the family, will continue during the period of disability. Dr. Solomon Huebner, the eminent educator in the field of life and health insurance, referred to disability as "living death". He reasoned that disability is the most traumatic form of economic death because not only is one's income cut off during this time, but other funds will have to be used to pay for the additional costs of medical treatment and rehabilitation. Until recently the disability contingency had always taken a back seat to premature death and retirement. Most people, when asked what their greatest asset happens to be, would probably answer that it was their home, automobile, personality, ambition, or the parcel of rental property they own in Maine. While all of these are unquestionably important assets, many of us fail to recognize what our most important asset is. Financially speaking, a person's greatest asset is his or her ability to work and earn an income. For example, an individual who is 30 years of age and who earns $3,000 per month, will earn over $1.25 million during his or her working years (assuming retirement at age 65). A lack of farsightedness on the part of both the individual and the insurance industry relegated disability to the bottom rung on the ladder. Millions and millions of dollars are spent each year protecting one's life, home, auto, golf clubs, and so forth. What we have failed to realize is that we are neglecting to protect what makes these and almost all of our other material possessions possible - our income.
The Purpose of Disability Income Insurance
The purpose of disability income insurance is to replace (partially or wholly) the income of individuals who are unable to work and earn an income due to a covered accident or sickness. Numerous means of protecting one's income have evolved during the last 50 years. For example, individual disability income insurance contracts, paid for by the insured, are designed to protect one's income on an individual basis. Generally, most individual disability income contracts provide, in monthly benefits, approximately 60% of one's monthly income. Benefits are usually paid on a monthly basis following the elimination period stated in the contract. On the other hand, group disability income insurance is designed to provide for partial replacement of earnings lost during disability. This type of disability income may be characterized by a weekly or monthly payment, and the payment amount is generally determined by the worker's normal rate of pay. In this situation, payments begin after a fixed minimum period of absence from work and they continue during disability up to a fixed maximum time limit. Those contracts with maximum benefit durations of up to two years are generally considered short-term disability policies. Those with longer durations are referred to as long-term disability policies. For the most part, employers are less likely to provide their employees with disability income benefits than with medical expense or life insurance benefits. It is sometimes difficult to estimate the exact extent of disability coverage because benefits are not often insured and employees are sometimes covered by overlapping plans. In any event, a reasonable estimate would be that no more than 66% of all employees have some form of short-term disability income protection which is provided by their employer. Only 33%, approximately, have protection for long-term disabilities. This is not to say that all employees have some type of disability protection and, conversely, many of the aforementioned employees who have this coverage have both short-term and long-term protection.
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Basically, group disability income insurance consists of two separate types of policies - short-term and long-term disability income protection. Short-term disability income insurance has often been referred to as accident and sickness insurance or weekly indemnity insurance. Long-term disability income insurance provides extended benefits to a specified age, or for life, after an employee has been disabled for a specified period of time (usually this period of time is six months). In a case where both short-term and long-term disability income plans are provided to employees, a pair of coordinating tasks are necessary with regard to the designing and underwriting of group disability income plans. The first involves the fact that each plan must be coordinated with the other. The second involves coordinating both plans with other benefits for which employees may be entitled by way of social insurance programs or uninsured salary continuation plans. The failure to coordinate these plans together or with other benefits may lead to such a generous level of protection for employees that false disabilities or malingering will occur.
Short Term Disability Since there are several differences between short-term and long-term disability income programs, group plans frequently include both short-term and long-term benefits. There is often a difference in the categories of employees to whom short-term and long-term plans apply. For example, hourly paid (rank and file) employees may be covered only by a short-term plan. However, employees receiving a salary may be covered under a long-term disability plan or a combination of both. Short-term disability income benefits are usually provided to employees by way of employee benefit plans. Traditionally, STD benefits are provided for one year or less. Short-term disability benefits differ from long-term benefits in a variety of ways. Some of the characteristics of STD plans include, but are not limited to:
Definition of Disability Most short-term disability income plans define disability as "the inability to perform the employee's own occupation". "Own occupation" is also referred to as "his or her occupation" coverage. This definition has also been described as the total and continuous inability of an employee to perform any and every duty of his or her regular occupation. Some restrictive policies even go so far as to say that in order for an individual to qualify under its definition of disability, the employee must be unable to engage in "any" occupation for compensation. In order to qualify for disability income payments under a short-term plan, an employee must be:
§ Totally disabled as a result of a covered accident or sickness. § Prevented by the disability from performing the duties of his or her occupation. § Determined to be disabled by a licensed physician.
The insurer's definition of disability includes 24-hour coverage. In other words, the definition includes both occupational and non-occupational disabilities. Like long-term disability plans,
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short-term disability benefits will be reduced by benefits payable under any social insurance vehicle, such as Social Security or Workers' Compensation, in order to avoid a duplication of benefits. Providing duplicate benefits under short-term plans and Workers' Compensation, for example, is undesirable. As with any disability income program, an employee will have less incentive to return to his or her employment if it is possible to receive income from both types of plans. Therefore, a coordination of benefits provided by the two plans (short-term disability and social insurance programs) must be initiated. Amount of Benefits In many cases, the amount of benefits provided by a short-term plan will vary from that of a long-term disability income program. For example, in some short-term plans, an employee may be paid 100% of his or her earnings for the first six weeks of disability. During the remaining twenty weeks of disability, the employee is paid 60% of his or her earnings (assuming that this short-term plan paid benefits for twenty-six weeks or six months). Most long-term disability programs provide benefits limited to 50% to 70% of earnings. Elimination Periods An elimination period is also known as a waiting period. This is the period of time which must elapse before benefits will be payable to a disabled employee. An elimination or waiting period is sometimes considered the equivalent of the deductible found in major medical policies. During a waiting period, an employee is paid no monthly disability income benefits. Formerly, elimination periods for these plans ranged from zero to 14 days. In addition, shorter elimination periods, or none at all, existed for disabilities resulting from accidents as opposed to those resulting from sickness. Today, in some cases, disability income plans include elimination periods referred to as co-terminus. This means that the elimination or waiting period will be exactly the same for disabilities due to accidents or illnesses. A number of group disability income insurers continue to have split elimination periods even though many disability income carriers provide co-terminus benefits. The reason why companies underwrite different elimination periods for accident and sickness disabilities is based on several factors including:
§ Most disabilities are caused by sickness. § An insurer wants to control potential claims costs for disabilities of short duration. § It is easier to claim that one is ill as opposed to being disabled as the result of an accident.
Probationary Periods This is the period of time after a policy is issued, in which no coverage is afforded. A probationary period is a one-time occurrence and usually applies only to disability resulting from a sickness. Disabilities occurring as a result of accidents are usually covered immediately. For example, a short-term disability plan may state that coverage will not go into effect until the covered person in question (employee) has been employed for thirty days. Other plans have probationary periods of sixty or ninety days. The period of time depends on the contract itself.
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Plan Financing Short-term disability income plans may be financed or paid for on a contributory basis, where both the employer and employee share part of the cost. Other plans may be non-contributory, where the employer pays the entire cost. Another type of financing involves employee-pay-all plans. However, short-term disability income plans are rarely financed using this method. In short-term disability income plans, the tendency is toward non-contributory financing. Again, this means that the employer will bear the entire cost of the plan. Approximately 70% to 80% of companies provide non-contributory short-term disability.
Benefit Amounts
Weekly Income As previously mentioned, the basic purpose of a short-term disability income policy is to provide a moderate level of income for an employee's lost wages as a result of non-occupational illness or accident. Once again, benefits begin once the elimination period has elapsed. Weekly income benefits under a short-term group plan are based upon an employee's earnings, as is the case with most disability income policies. Benefit amounts typically range from 50% to 66.6 % of the employee's gross weekly income. With respect to insured plans, insurers use underwriting criteria which allows them to keep short-term disability benefits from exceeding 50 % to 66% of the employee's gross wages. In addition, many states include a "relation of earnings to insurance" provision which aids in keeping benefits from becoming too high in relation to the employee's earnings. The higher the benefit-to-earnings relationship, the greater the chance for employee malingering. For example, if an employee participates in a short-term group disability income plan which pays 90% or 100% of salary in the case of disability, the incentive for that employee to return to work as soon as he or she is healthy is drastically reduced. What incentive would an employee have to return to work if he or she is receiving disability income benefits close to their regular weekly wage? The use of an appropriate waiting period may be significant in this situation since it would help to reduce plan costs and possible employee absenteeism.
Benefit Duration
Benefit Payment Periods Generally speaking, short-term disability income plans have maximum benefit durations (benefit payment periods) of 13, 26 or 52 weeks. In some cases, short-term disability plans may pay benefits for as long as two years. To ensure that a short-term disability income plan works efficiently, the benefit period under the short-term plan should be coordinated with the elimination period under any long-term plan. As noted previously, a lack of coordination, between an employer's short-term and long-term plans may pose real problems.
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Continual Periods of Disability Continuous Disability In many cases, short-term disability plans specify when continual periods of disability are to be considered as separate disabilities with separate elimination and maximum benefit periods. These plans also specify what is to be considered as one continuous period of disability. This distinction is sometimes determined on the basis of whether the employee returns to active employment for a specified period of time. The purpose of a provision to regulate continuous periods of disability is important since it helps to prevent disabled employees from starting a new maximum benefit period by returning to their job briefly when their disability is really continuous. For example, an employee is covered under a short-term group disability income plan which provides him/her with 60% of earnings for a period of thirteen weeks. Let us assume that this employee receives disability payments for the thirteen-week period. After returning to his/her job for three weeks, the same condition flares up and the employee is disabled once again. However, due to provisions included in the contract regarding continuous or successive periods of disability, a new benefit period will not begin since this employee's disability is actually a continuation of the one for which he/she previously collected thirteen weeks of benefits. So this employee will not be able to begin a new benefit period unless it is clear that the continuous disability arose from an unrelated cause.
Exclusions For the most part, there are few exclusions found under a short-term group disability income plan. Basic exclusions found in these contracts include:
§ Disability due to intentionally self-inflicted injuries. § Disability as a result of occupational disabilities for which Workers'
Compensation or similar benefits are payable in non-occupational type plans. § When a disabled employee is not being treated by, nor is under the care of, a
licensed physician. § While a disabled person is working for profit or pay. § Disabilities arising from war or acts of war.
Termination of Coverage
Cancelable Contracts The majority of short-term disability plans are cancelable contracts. This means that the insurance carrier may cancel the policy on any policy anniversary date. Although this action is rarely taken, the company continues to have the ability to cancel a contract if it is in their best interest to do so. These contracts may also be canceled by the insurance carrier on any premium due date when the number of covered employees or participants drops below some stated minimum or percentage of those eligible. Of course, an employer has the ability to cancel a policy on any premium due date as well. An employer who simply fails to pay the appropriate premium on time will find that the group plan will terminate following the 30-day grace period.
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Coverage may also cease under this type of plan upon the termination of active employment by an employee. Due to the fact that the employee's wages have ceased, there can be no income loss resulting from a subsequent disability. Insurers have seen that if disability income insurance is continued during periods of lay-off, leaves of absence, or following the simple termination of employment, it is likely to be used as a form of unemployment compensation. In addition, claims would be prolonged beyond their normal or proper duration and false claims would be reported which will increase company expenses.
Long-Term Disability Income
Long-Term Disability The second major category of group disability protection involves long-term disability income insurance. This type of protection provides extended benefits after an employee has been disabled for a period of time. Long-term disability benefits are typically considered to be those with a maximum duration of two years or more, but they are usually at least five years in duration and may be extended for the life of the insured. Even though a permanent disability brings with it a greater potential for economic ruin, long-term disability and other disability income plans are too often overlooked.
Definition of Disability When defining the contingencies covered, long-term disability income policies often make a distinction between disability which prevents the pursuit of an individual's usual occupation and disability which results in the inability to perform "any" type of work for compensation. In this respect, one constantly used provision defines disability with respect to an initial period, such as two years, as the inability of an employee-participant to perform "any and every duty pertaining to his or her occupation". If disability continues beyond the two-year initial period, further payments are then conditioned on the more severe test that the disability must be of sufficient severity to prevent the claimant from engaging in any employment whatsoever. In this manner, if a claimant recovers sufficiently to be able to do some work, he or she may be expected to accept a job in any occupation that he or she is capable of performing. Otherwise, his or her payments would be terminated. The definition of disability in an LTD plan, as far as the "his or her occupation" definition is concerned, is the same as used in short-term plans. If the disability continues beyond that initial period (one or two years), the disabled employee will continue to be considered disabled only if he or she is completely unable to engage in any gainful occupation for which he or she is (or may become) reasonably fit by education, training, or experience. This addition of education, training, and experience is present in most long-term disability and individual disability income contracts today. This separation approach with reference to the individual time periods involved is sometimes referred to as "split definition". The effect of this split definition is to allow a disabled employee to receive disability income benefits on the basis of being unable to perform his or her own occupation for a reasonable period of time. Following this reasonable period of time (i.e., two years), the disabled employee must satisfy the more stringent occupation definition in order to continue receiving long-term disability benefits.
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Although this definition is more stringent than that found in a short-term plan, it is not as restrictive as the definition of disability found under Social Security. With Social Security, in order to be considered disabling, the disability must be severe enough to prevent the worker from doing substantial gainful work and must last or be expected to last for at least twelve months or result in death. This will be discussed further with regard to the amount of benefits provided.
Individual and Group Long-Term Disability Income Coverage
Long-Term Disability Long-term disability income protection may arise from several sources including Social Security, Workers' Compensation, individual and group long-term disability plans, disability income provisions under group life insurance, and disability provisions under pension plans. The most important of the aforementioned five, is group long-term disability. These benefits are designed to provide income replacement for lost earnings and salary when a disability has lasted for a long period of time and is expected to be of a long duration (or total and permanent). The claims which arise from long-term disability are different from those of short-term plans. Long-term disabilities occur infrequently but those that do occur last for long periods of time. Short-term disabilities tend to occur more frequently but with a shorter duration. Therefore, long-term disabilities are those of low frequency and high severity while short-term disabilities are those of high frequency and low severity. The majority of long-term disability plans are written by insurance carriers. However, due to rising health and administrative costs, large employers and corporations are beginning to explore the concept of self-funding their long-term disability plans. This may also apply to short-term disability income plans as well.
Benefit Amounts Long-term disability plans usually provide monthly income benefits which range anywhere from 50% to 66.6% of the disabled employee's base salary. Some plans are available which provide benefits as high as 80% of salary. The relation of earnings to insurance provision, discussed in connection with short-term plans, would also apply to long-term disability as well. For the most part, long-term disability plans are integrated or offset by other types of disability benefits to which disabled employees may become entitled. The benefit amount to be received by a long-term disability plan, in this situation, will be reduced by the amount received from a social insurance program, such as Social Security or Workers' Compensation. The effect of the offset or integration provision is that the maximum benefit otherwise payable from the long-term disability plan will be reduced by other specified types of disability benefits payable. Other disability benefits, in addition to Social Security and Workers' Compensation, which may trigger an integration provision include benefits received according to state disability income law, disability benefits received under the employer's pension or other retirement plan, an employer provided separation allowance, and a full or partial wage paid by an employer. Let us look at an example of how this offset or integration provision works. Joe Smith, age 35, earns a salary of $3,000 per month. Joe is covered by a long-term disability plan at work which provides a benefit of 60% of his base salary. Joe becomes disabled as a result of his involvement in an automobile accident. Since his monthly salary is $3,000, 60% of that amount, or $1,800,
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would be paid to Joe each month under his LTD plan. However, Joe also qualifies for disability benefits under Social Security. Let us assume here, that Joe receives $650 per month from Social Security. Since Joe's LTD plan is integrated with Social Security, the amount collected from Social Security must be subtracted from the $1,800 per month figure. Thus, Joe would receive $650 from Social Security and $1,150 from his LTD plan for a total of $1,800 in benefits. These figures have been chosen arbitrarily simply to illustrate that the LTD benefit is offset by Social Security and would change if a family benefit were involved under Social Security. Duration of Benefits Long-term disability income benefits usually begin after short-term benefits or salary continuation payments cease. In some cases, they precede or may supplement disability income payments under pension plans. In order to integrate benefits with such plans, the long-term disability policy usually has a long waiting period, at least equal to the benefit period under the short-term benefit plan (or salary continuation plan). A six-month period is common in most instances. Even where the long-term plan is the only disability benefit, it usually involves a longer waiting period such as thirty, sixty, or ninety days. There is a broad diversification in the maximum duration of benefits. Some contracts possess a maximum period as short as two years. Others provide benefits until the individual reaches his or her normal retirement age (i.e., age 65). Still others have a lifetime benefit for disability due to accidents. Benefit durations will vary by company, but the most common include two years, five years, ten years, benefits to age 65, and benefits for life. These benefit durations will not be offered to everyone. For example, some companies will not offer a carpenter benefits for life, but will make this offer to a physician or attorney. Other LTD plans may vary the benefit duration for different classes of employees or for those employees with more years of services. Choices made among the aforementioned possibilities depend upon the other provisions which the employer may make for disability protection. In some cases, these may be influenced by collective bargaining. The nature and duration of employment, the patterns in the particular disability income industry, and the accompanying costs and expenses are other factors which must be considered.
Elimination Period As previously noted, elimination or waiting periods under long-term disability plans are usually of a longer duration. The elimination period chosen will sometimes depend upon any other short-term disability, salary continuation, or employer sponsored benefit provided to an employee. Hypothetically, elimination periods in LTD programs may range anywhere from thirty days to twelve months.
Probationary Periods The probationary periods found under short-term and long-term disability plans are very similar. However, they may differ with regard to their length depending upon the insurer and contract involved.
Continuous Periods of Disability Many long-term disability plans involve employees who become disabled, receive disability income benefits, return to their job, and then experience another period of disability. Generally
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speaking, long-term disability plans provide that such periods of disability which are separated by less than a specified period will be considered as one continuous period of disability. However, a situation may not be considered continuous if the disability is caused by something unrelated to the previous disability (and it begins following the employee's return to work on a regular basis). This is similar to the continuous period of disability information found in the short-term disability discussion.
Other Provisions Many provisions found in long-term disability income plans (or in most group plans) are similar to those contained in group term insurance contracts. In addition, mandatory provisions are found in all of these contracts as well as optional provisions, which are included in some depending upon the particular state involved. Other provisions found in long-term disability programs most commonly include survivors' benefits, rehabilitation provisions, and pension supplements.
Survivors' Benefits Some long-term contracts provide a benefit to survivors in the form of continued payments after the death of a disabled employee. This means that the disability income payments will be continued, possibly at a reduced amount, for periods ranging up to two years. These payments are usually made only to an employee's surviving spouse and dependent children under age 21.
Rehab Other long-term disability plans have provisions which are included for the purpose of encouraging the rehabilitation of a disabled employee. This type of provision provides a cost saving mechanism for employer and insurer. The coverage or benefits provided under this provision will vary among companies. Generally speaking, most of these provisions state that partial benefit payments will continue when a previously totally disabled employee returns to work in some capacity.
Pension Supplement Another type of benefit found in some LTD programs is a pension supplement. This particular benefit will be discussed later.
Return of Premium Rider (RPR) In the mid-1960s, an insurer began marketing a disability income policy which included a Return of Premium Rider (RPR). This provision introduced a policy that paid when you were sick, injured, or disabled, but also paid when you remained in good health. The idea was a simple one:
§ Offer the rider as an option and charge an additional premium for it. § At the end of each ten-year period, the insured would receive a refund of 80% of
his/her total premiums, less claim payments not exceeding 20% of the premium payments.
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§ If claim dollars exceeded the 20% figure, no refund would be payable. However, a new ten-year period would begin on the policy anniversary next following recovery.
§ In the event the insured died or reached age 65, the 80% return of the paid premiums, less any claim payments, was paid to the beneficiary or the insured, respectively.
§ If the insured wished to discontinue the rider but keep the disability coverage in force, this could be done at any time. If the rider was terminated before the end of a ten-year period, there would be no return of paid premiums.
Many insurance companies were intrigued by the Return of Premium Rider, for two basic reasons:
§ Their concern for persistency of disability income policies. § The potential market demand for a benefit to be paid to individuals who have
better-than-average claims experience.
Cash Surrender Value Feature During the early years of development of the Return of Premium provision, a similar concept was spawned and developed: the Cash Surrender Value (CSV) feature. Some companies labeled this provision "Return of Premium," a confusing misnomer. Although the idea of Cash Surrender Value was as simple as that for the Return of Premium, there were distinct differences between the two provisions:
§ The Cash Surrender Value feature was offered as an integral part of the policy, not as a rider, and an extra premium was charged, as with Return of Premium.
§ Starting after the third policy year, the CSV provision began to build cash surrender values.
§ The cash surrender values continued to grow so long as the policy remained in force, eventually equaling at age 65 an amount which was 100% of all premiums paid.
§ If claims exceeded the total premiums at age 65, no surrender value was payable. § If the insured died prior to age 65, the cash surrender value would be payable to
the beneficiary. § The only way to discontinue the CSV feature would be to terminate the policy.
At the end of ten policy years, for example, the typical cash surrender value might be 25% to 50% of the premiums paid (less claims), depending upon the insured's age at the time of policy issue.
§ If the policy was terminated and the CSV paid out, no reinstatement would be permitted.
Return of Premium tends to reduce an insurer's profit from the basic disability income policy, but it so improves volume and persistency that the total dollars of profit exceed the total which would be obtainable by writing the basic policy without Return of Premium.
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The concepts of Return of Premium and Cash Surrender Value revolutionized the disability income business by offering claim dollars and/or return premium dollars to every insured. The resultant impact on policy persistency has been dramatic: lapsing disappeared. Advantages: 1. Removal of the disability "gamble". Get paid if you become sick or hurt and disabled; get paid if you stay well or reasonably well. 2. The option of discontinuing the Return of Premium or Cash Surrender Value riders at any time, retaining the basic policy. 3. An attractive internal rate of return on Return of Premium at the end of each 10-year term period. 4. The RPR may be added to the basic policy on any anniversary date at the same additional cost as when the policy was issued. Disadvantages: 1. A minimum 50% additional premium is required to include the RPR or CSV rider. 2. No return is paid on Return of Premium if the rider is dropped from the policy before a 10-year term is completed. 3. If the CSV rider is discontinued before age 65, no surrender value is payable unless the policy is surrendered. They're not for everybody, but Return of Premium and Cash Surrender Value provide interesting alternatives for those who don't want "plain vanilla" disability income protection.
Plan Financing The methods used to finance long-term disability benefits are different from those used for short-term plans. A LTD plan may be financed on a contributory, non-contributory, or employee-pay-all basis. In this respect, long-term and short-term plans are similar. In most cases, however, long-term disability plans are financed either on a contributory or employee-pay-all nature.
Exclusions The exclusions found in a long-term disability plan are similar to those found in a short-term plan. Although these will vary by contract, the exceptions found in most LTD contracts include, but are not limited to:
§ Disabilities as a result of war or an act of war. § Intentionally self-inflicted injuries. § Disabilities as a result of mental illness (attempted suicide). § Disabilities resulting from the participation in a felony or other felonious act. § Disability resulting from alcoholism or drug addiction.
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§ Disabilities as a result of a pre-existing condition (these are usually limited to smaller group plans).
Disability Income in Pension Plans Previously, we alluded to the fact that disability benefits are provided in some pension plans. In addition to income benefits for disability, pension plans have provided an accrual benefit in long-term disability programs. Such a pension accrual continues the build-up of a disabled employee's pension benefits from the date of disability until normal retirement age (as if the employee had continued as an active employee). This benefit is similar to the disability freeze provision found under Social Security benefits. The Social Security disability freeze means that the years of disability need not be considered in computing survivorship or retirement benefits. The disability provisions found in a pension plan are also similar to the concept of waiver of premium with regard to other types of individual policies and employee benefits (i.e., whole life and group term life insurance).
LTD vs. Individual Disability Income Policies
Basic Differences Although the basic benefits provided by an LTD program and an individual disability income policy are similar (as far as providing disability benefits are concerned), there are some basic differences regarding the construction of each particular contract. When referring to an individual disability income policy, we mean one which is non-cancelable and guaranteed renewable. Thus, a major difference between this type of plan and a group long-term disability income plan centers on the fact that a group LTD is cancelable. If the claim experience of the group covered by an LTD program is too great in the eyes of the insurance carrier, the company may cancel the contract. However, in an individual non-cancelable and guaranteed renewable contract, the policy may not be canceled as long as the insured's premium obligations are met. Furthermore, an LTD program may have its premium increased, whereas an individual policy may not. A further distinction between the two types of plans involves the fact that an individual plan is more portable than an LTD program. If an employee leaves a particular firm, his or her LTD benefits will cease. Finally, in most LTD programs, the benefit amount may be integrated or offset by any social insurance amounts paid to the disabled employee. In an individual disability income policy, benefits are paid in addition to any funds received by the disabled individual. In other words, there is no integration with social insurance programs such as Social Security and Workers' Compensation, with an individual disability income policy. This information has not been provided in order to imply that an individual disability income policy is more advantageous than a group long-term disability income policy. There are definite needs and markets for each of these types of products. When cost is the determining factor, a group LTD program may be the best vehicle to use. When cost is not a determining factor, an individual plan may serve as the best vehicle. Whatever the case may be, the type of plan or program chosen will depend upon the goals, objectives, and needs of the parties involved.
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Taxation Information
Taxes Another area which should be mentioned regarding group disability income plans is the area of federal taxation. As with group life insurance, employer contributions for employee's disability income insurance are fully deductible to the employer as an ordinary, necessary business expense if the compensation is reasonable. Contributions made by an individual employee are considered payments for personal disability income insurance coverage and are not tax deductible. In contrast to group life insurance, where employer contributions may result in some taxable income to an employee, employer contributions for disability income insurance result in no taxable income to an employee. However, the payment of benefits under an insured plan or salary continuation plan may or may not result in the receipt of taxable income. In making this determination, it is necessary to look at whether the plan is fully contributory, non-contributory, or partially contributory.
§ Fully Contributory Plans: Under this type of plan, where the entire cost is borne by employee contributions, benefits are received free of income taxation.
§ Non-contributory Plans: Under this type of plan, where the entire cost is borne by
the employer, benefits received are included in an employee's gross income (although tax credits may be allowed to persons who are permanently and totally disabled).
§ Partially Contributory Plans: Under this type of plan, benefits attributable to
employee contributions are received free of income taxation. Those benefits attributable to employer contributions are includable in gross income, but employees are eligible for the tax credits referred to above.
In addition, some states treat benefits received from disability income plans the same as the federal government. In many instances, the benefits received by such plans are treated more favorably under state law than under its federal counterpart.
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Chapter 3 Objectives Upon completion of this section, you will:
§ Gain increased knowledge about salary continuation and association plans. § Be better able to apply increased knowledge of varied applications to clients’ situations.
Chapter 3 Salary Continuation and Association Disability
Income Plans
Environment an Marketplace The insurance industry is undergoing rapid and fundamental change. Bankers, stock brokers, and financial planners are emerging as serious competitors for the consumer's "financial service" dollars. New technologies are making more complicated products and services the standard. Consumer needs and buying patterns also are changing, in part because of the pervasive influence of the huge "baby boom" generation. That group is just now entering its peak earning years. Consumers are also better informed as to relative product values and are receptive to the benefits of buying even individual products on a group basis. All of these factors have had a dramatic influence on insurance marketing. The day when selling across the kitchen table was the norm has given way to different methods. Substantial incomes for insurance producers must now be generated by limiting prospecting only to the most affluent buyers, if sales are made to one person at a time. Most producers have found that multi-life sales provide an opportunity to make a greater number of sales to a wider market, thereby increasing the return for the time investment required to contact, interview, analyze, propose, close, and place a sale. Multi-life sales also can open up new markets. Almost all new jobs created in the United States over the past several years have been in small businesses. The majority of these businesses have no agent or broker and have never been approached for insurance coverage. Prospects also can be found in the memberships of thousands of associations of every type and description. Associations are often interested in providing insurance to their members as a benefit of association membership. The sale of salary continuation plans to businesses and the sale of disability income plans through associations are two proven methods of making multi-life sales.
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Because this assignment deals with both salary continuation and association plans, it is important to differentiate between the two.
Salary Continuation Plan A salary continuation plan is one in which there is an employer/employee relationship, as evidenced by the fact that the employer deducts federal income taxes or Social Security taxes (FICA), or both.
Association Plan As association plan has no employer/employee relationship, but typically consists of members of a legally chartered association of persons engaged in a similar occupation. A state dental association, a national association of hat manufacturers, a local association of advertising executives, or a county association of optometrists are examples of associations eligible for insurance solicitation and coverage under "association plans".
Salary Continuation Plans
"Sick Pay" Plans The Internal Revenue Code (IRC) refers to salary continuation plans as "sick pay" plans, but clearly it also covers disability for accidents. Salary continuation plans replace lost income during periods of disability. The plans may or may not be funded by insurance policies. Such plans usually replace lost income fully for a limited period of time and may provide benefits beginning with the first day of disability. The IRS allows an employer to deduct as a business expense, sick pay or insurance premiums paid for sick pay coverage, provided that there is a valid sick pay plan in effect. A plan is considered valid if it is:
§ In writing. § Set up so that employee's rights are legally enforceable. § In effect prior to an employee's disability. § Set up with the intention of maintaining it for an indefinite period of time. § Communicated to the employees, including the amount and duration of benefits. § Set up solely for employees. Different classes of employees may have different
plans. § Not unreasonable in the amount of benefits provided in relation to services
performed by the employee. Payments made under a salary continuation plan are eligible for a tax credit for the disabled employee if the employee:
(a) is age 65 or older, (b) retired due to disability, or (c) meets the Social Security test for disability.
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The test is the inability to engage in any substantial gainful activity in the national economy by reason of a disability that can be expected to result in death or that has lasted for a continuous 12-month period. It may be observed that the definition of disability for social security purposes is so stringent that few disability-retired persons will actually qualify for the credit. If the benefit recipient under a salary continuation or association plan is not disability-retired, then, as with any disability income plan, the benefits are included in taxable income to the extent they were funded by employer contributions. If benefits are received from a plan to which the employee (or association member,) has contributed, the portion of the benefits that are attributable to the employee's contributions is received tax-free. It is important to realize that, when premiums are deducted by the corporation, these premiums are not considered as income to employees. However, disability benefits received by the employee are considered taxable income. Premiums paid on behalf of partners, sole proprietors or owner/employees of Subchapter S corporations are not deductible. The benefits received, however, are income tax-free when the premiums are not deductible. It is important to relay this information, but the salesperson would be well advised to suggest that the final decision on whether or not to deduct should be referred to the client's legal counsel or tax advisor.
FICA When the employer pays the premium, the insurance company is required to deduct the Social Security tax (FICA) attributable to the employee for the first six months of disability. For example, in the event of a 90-day elimination period, only the last 90 days would be subject to this ruling, and in the event of a six-month elimination period, there would be no payments deducted under these provisions. When an employee pays the premium him/herself, there is no deduction for FICA by the insurance company. When the premium is split between the employer and the employee, the FICA deduction is in proportion to the percentage of premium paid by the employer. Benefit payments made to an employee under a plan that does not conform to the IRS requirements are considered "ad hoc" payments and, as such, are not tax-deductible or eligible for the sick pay tax credit. Sick pay plans do not have to be filed for approval with the IRS. However, sick pay plans are considered welfare benefit plans and, as such, are within the scope of the Employee Retirement Income Security Act (ERISA). The rules for sick pay plans with fewer than 100 employees are simple and can be satisfied by having a written plan that is communicated fully to the employees. Plans with 100 or more participants must comply fully with the requirements of ERISA.
Employee Benefits
Salary Continuation Plans It is obvious that employee benefits, which account for more than one-third of total pre-tax compensation, are in the forefront of any employer's mind. It is also obvious that employee morale can be seriously affected by the manner in which a disabled employee is treated.
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However, in addition to these aforementioned reasons, there is a powerful ally for handling of salary continuation plan sales in the tax code. Basically, if the employer continues his own or any other employee's salary without benefit of a formal sick pay plan, that payment may be called an "ad hoc" payment. In this event, the payments may not be considered necessary business expenses and therefore, are not deductible. In addition, "ad hoc" payments to stockholder employees could be classified as dividends (not deductible to a corporation, and ordinary income to the stockholders). Another question to consider is whether the owner has established a precedent by paying himself or a key employee. Therefore, it becomes important for the salesperson to point out that, by establishing a formal sick pay plan, the premiums may be deductible if the IRS requirements noted previously are met. Insurance companies usually will provide sample corporate minutes, plan documents, and summary plan descriptions to assist in establishing a valid, deductible plan for IRS purposes. Generally, disability insurance in salary continuation cases is either group insurance, long-term disability (LTD), or individual policies. Group insurance is cancelable and is usually sold on a short-term (90-day, 180-day, etc.) basis, but may be provided on a long-term basis. LTD is cancelable and generally provides long-term benefits (often to age 65), usually the same benefit period and same percentage of salary to all (generally, 66.6%). LTD plans typically offset benefits received from other sources in order to ensure that benefits do not come too close to the insured's take-home pay. These benefits, deducted from long-term disability, may be:
§ Social Security benefits. § Workers' Compensation benefits. § Benefits payable under a plan sponsored by the employer. § Benefits payable under a pension or retirement plan of the employer.
The advantage of installing individual non-cancelable policies in a "salary continuation" plan is that the employer does not have to face future premium rate increases or cancellation if the claim experience is higher that expected by the insurance company. On the other hand, these policies require individual underwriting (sometimes on a somewhat looser basis and, rarely, on a guaranteed standard issue basis). The premiums are higher than those under group LTD coverage, so it is up to the salesperson to discuss these possibilities (pro and con) with the employer when the decision is made to investigate a plan.
Funding
Self-Funding Employers often will inquire about self-funding a plan. Such an arrangement is absolutely legal, provided the other steps are followed, i.e., adopt a formal plan, put benefits in writing, communicate the plan to covered employees, etc. There are, however, certain financial disadvantages to self-funding:
§ Premiums paid to an insurance company are deductible whereas contributions to a self-funded contingency reserve are limited in their deductibility. Generally, an
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employer can only deduct contributions when benefits are "paid" to an employee, plus any claims incurred but not paid at year-end, less any net investment income earned by the fund.
§ Multiple losses are covered by insurance companies, but they could be
catastrophic to a self-funding company.
Methods of Payment
Employee Pay System What if the situation arises where an employer likes the idea of a salary continuation plan but does not want to pay the premiums? If the idea is sound and it appeals to the employer, there are other methods to accomplish the same result.
Employee-Pay-All The employee-pay-all system assesses no cost to the employer, except for the minor amount of time the salesperson spends with the employees and the necessity for the employer to payroll-deduct (because the employees will now pay the premium). If the employer agrees to the concept of payroll deduction, it will be necessary (in LTD plans as well as individual plans) to solicit the employees individually. Generally, individual plans do not allow mail solicitation but require that each individual sign an application taken by a salesperson or by a solicitor hired by the salesperson. There are some very clear advantages for everyone concerned in the case of payroll deduction:
§ There is no dollar cost to the employer. § The salesperson has far better control of the case because, in future years, one
person in the company cannot make a decision to bring in another salesperson as a replacement. Each individual would have to be resolicited by the new salesperson.
§ In the event of future financial problems, the company will not drop this employee benefit since it is not paying the premiums.
§ Generally, insurance companies allow free coverage between the date of the application and the policy issue date, when payroll deduction is utilized.
§ The premiums are not paid by the employer and thus are not deductible. However, the benefits are income-tax-free, thus bringing in more after-tax income to the client when he or she becomes disabled.
Splitting the Premium There is also a third method of payment available: splitting the premium. There are two ways in which to accomplish this:
§ The employer can pay a percentage attributable to a specific benefit period (the first two years, for example), while the employee pays the portion attributable to those premiums for the balance of the coverage after two years (benefit to age 65, etc.). Any reasonable division may be made, and the insurance companies can provide the percentage of premiums attributable to both the employee and the employer.
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§ The employer can pay a certain percentage of the premium, with the balance being paid on a payroll deduction basis. In this event, the portion paid by the employer is deductible, and the benefits attributed to that portion are taxable.
In either event, the same rules apply as above for the deductibility of premiums and taxability of benefits. Therefore, in the first example above, the premiums attributable to the first two years would be deductible, the benefits for the first two years would be taxable to the employee, and the balance of benefits would be income tax-free. These plans all require a common (list) billing on a common billing date and, because the insurance company receives and processes only one check each time a payment is made, the companies often deduct a list billing discount from the premium due.
Executive Bonus Plan A fourth method for payment of these plans is often used in small corporations or on behalf of key employees of a corporation. It is called the "executive bonus plan", and it functions in the following manner: The executive in the 28% tax bracket has a premium of $1,500. If he/she paid the premium from after-tax dollars, he/she would have to earn $2,083 to pay the non-deductible $1,500. On the other hand, if the corporation paid the deductible $1,500 premium (after-tax cost, $900), the benefits would be taxable. Therefore, the corporation gives the executive a raise of $2,083 (deductible to the corporation). The executive pays a tax of $583 and a premium of $1,500, but because he/she paid the non-deductible premium, the benefits would accrue free of income tax. Association Disability Income Plans
Individual Disability Income Products Association disability income coverage commonly is offered on a group basis. Recently, there has been a trend by some professional associations for the endorsement of individual disability income products, which are then marketed to association members on a discounted basis, sometimes with more liberal underwriting. Association group disability income coverage is not like a typical group insurance contract, although there are some similarities. Group contracts require an employee/employer relationship. In some states, special provisions or statutes have been instituted for association groups. This type of coverage is offered to national, regional, or local associations of professional individuals, business people, fraternal organizations, and others who are joined together by a common interest. However, this common interest must not involve forming an association solely to purchase insurance coverage. In other words, a group of individuals may not form an association simply to be able to purchase health or disability insurance. Association contracts usually are issued to the association itself or, in some cases, to a trust. Depending upon the type of contract involved, an association member may be supplied with a certificate as evidence of coverage, in much the same manner as group insurance. A member also may be supplied with an individual policy if the association case is characterized by individually underwritten contracts. Association coverage uses some group selection and actuarial principles
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in underwriting and pricing the coverage to be issued. The underwriters and actuaries will be able to determine a rate and a product offering based on a specific level of participation if they are supplied with the appropriate criteria, such as the size of the association, the ages and sex of the participants, and specific benefits being applied for. The area involving participants may pose some problems for association plans. For instance, because no employer is involved in member participants, motivation to join will be less. Because solicitation for these types of cases is done through the mail, in many instances, the number of members participating may be low. This contributes to a further dilemma in that a low level of participation indicates a high degree of anti-selection. For this reason, insurers will involve themselves in association cases only when a large percentage of members participate. It is common for insurers to state that the acceptance of an association's plan is dependent upon a minimum percentage of members, or "eligible members", participating. Another similarity of association and group plans involves the fact that both may be subject to premium increases or cancellation, depending upon the type of contract written and the plan's experience. To further understand the concepts involved in an association case, let us look at a specific illustration. The employees of a hat factory could be covered under a salary continuation plan because, while they have diverse jobs, they work for a common employer. The members of the association of hat manufacturers, on the other hand, have no common employer. In order to get the benefits of group insurance, they must be written as members of a legally chartered association. Why would an association be interested in allowing an insurance company to write coverage on its members? Indeed, why do they sponsor this coverage and write letters to their members asking them to consider the coverage offered? An association exists for the benefit of its members. It must constantly attract new members and it must find ways and means of keeping them together as members.
Membership Benefits
Coverage One proven way to do this is to offer something to the members that they usually cannot get, and insurance coverage (specifically, disability income insurance), at a reduced rate on a preferred basis, offers just such an opportunity for the association. It is not necessary to "qualify" for coverage because the association does not pay the premium. It offers its members the opportunity to purchase coverage at a discounted rate, often on a very favorable underwriting basis. Thus, the members purchase their own coverage. In association cases, coverage may be written on a cancelable basis, but this is rare. Usually, it is offered on a modified basis (LTD) or a non-cancelable basis (individual non-cancelable). The modified renewable coverage generally can be altered or canceled only under the following circumstances:
§ The insured member leaves the association. § The insured no longer engages in the business or practice of the association
members. § If all like policies are altered in the same manner.
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§ If all like policies in the association are terminated. In some cases, these policies can be replaced by individual policies on a guaranteed renewable or non-cancelable basis at the insured's attained age.
Non-cancelable policies cannot be modified or terminated after they are issued, but are usually underwritten on an individual basis (sometimes in a more favorable manner). They are higher priced than modified renewable policies, so it is up to the agent or broker to explore the market and know what he or she is attempting to solicit.
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Chapter 4 Objectives Upon completion of this section, you will:
§ Gain increased awareness of disability risk exposures for our clients’ advantage. § Be better informed about the varied types, methods, valuation, and provisions of
disability buy out insurance.
Chapter 4 Disability Buy-Sell Agreements
Identifying Disability Risk Exposures
Options Let’s look at the disability risk exposures which face many businesses today. Let’s attempt to do this by discussing both life insurance buy-sell plans and disability buy-sell plans and their relationship with salary continuation plans. It is interesting to note that while most businesses have identified their life risk exposures, the health risk exposures have been overlooked. In the life insurance area, the owner of a sole proprietorship realizes that there is no distinction between the business and the person behind the business. There is also no legal distinction between the sole proprietorship business liabilities and personal liabilities. In the sole proprietor's case, liabilities are unlimited and not shared with anyone. Since, in a sole proprietorship, the individual and the business are one and the same, at the death of the sole proprietor the business ceases. At this point there are several options to consider:
§ The business may be passed on to heirs as a going concern, § The business may be liquidated and distributed to the heirs, or § The business may be sold to an employee as a going concern.
With respect to transfer to the heirs, do the heirs want to run the business and are they capable of doing so? If the business is liquidated, we normally find that liquidating brings only 25% to 50% of the value of the business assets to the owner. If the business is to be sold to an employee, will the employee have sufficient funds to buy the business? These concerns, in addition to the determination of the value of the business for estate planning purposes and providing funds for the estate to pay the proprietor's expenses, necessitate a life
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insurance buy-sell agreement. The life insurance buy-sell agreement would allow the heirs to receive the true value of the business in cash, provide capital for estate settlement costs, and assure that the future decided upon for the business can be carried out. The law states that without an express agreement to the contrary, a partnership terminates when a partner dies. What types of special problems are created in this situation? First, liquidation would cause financial loss for the heirs and survivors. Second, income paid to the deceased's family may cease. In addition, the estate may lack liquidity for debts and taxes. There may also be conflicts over the value of the deceased's business interest for estate taxation purposes. Finally, the surviving partners may be forced to work with inexperienced heirs. A life insurance buy-sell agreement allows for the orderly change in the ownership of a business at the death of a partner. The agreement decides who will control the business, the deceased's estate will obtain liquid assets, and the value of the business will be established for estate taxation purposes. As we have seen, without a life insurance buy-sell agreement, the continuation of a business may be jeopardized. Heirs may not receive the full value of a business because of liquidation or a forced sale. In addition, without determining the value of the business for estate planning purposes, the amount of taxes owed is uncertain. So how does a life insurance buy-sell agreement help? It recognizes the life risk exposure that a business possesses and plans for the uninterrupted continuation of the business or the sale of the business to a pre-determined buyer for a pre-determined price. The future buyer of the business normally purchases a life insurance policy on the life of the business owner which makes the proceeds payable to the future purchaser. Under the agreements of the buy-sell contract:
§ The estate is obligated to sell to the purchaser at the stipulated price. § The purchaser is obligated to buy from the estate at the stipulated price. § The purchaser possesses the life insurance proceeds that are needed in order to
purchase the business. This results in the determining of the value of the business for estate planning purposes and the receipt of the full value of the business by the survivors
The Importance of the Buy-Sell Agreement
Health Risk Exposure This above was a brief overview of the importance of the life insurance buy-sell agreement illustrating its purpose and how it is utilized. At this point, let us return to the primary purpose of this assignment which involves the health risk exposure facing a business. Be aware that statistics demonstrate that the probability of an active business owner becoming totally disabled before retirement is much greater than the probability that he or she will die prematurely. It is generally accepted that there is an 88% chance that out of a group of six, twenty-five-year-old men, there will be at least one death prior to age 65. If we compare this fact with statistics based on the Commissioners Disability information, out of the same six members of the twenty-five-year-old group, the probability of at least one long-term disability prior to age 65 is 97.8%. A long-term disability in this case is defined as one which lasts at least 90 days. The statistics show that there is a high probability of disability prior to age 65.
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Business Overhead Expense Policy
BOE Policy Many of the problems that a sole proprietorship would experience due to disability can be handled by a personally owned disability income policy and a Business Overhead Expense (BOE) policy. The disability income policy would partially replace the loss of income and the BOE would reimburse the proprietor for continuing business expenses. With a partnership and a closely-held corporation, the disability of a partner or stockholder creates some special problems. First of all, the bargaining positions of the parties involved will no longer be equal. In most partnerships and close corporations, the partner or stockholder contributes to the success of the business. At the time of disability, however, these individuals become a liability rather than an asset. How long can the business continue to pay their salary while they are disabled and not contributing to the operation of the firm? In the event that the disabled partner or stockholder wishes to sell his or her share to remaining partners or stockholders, will the remaining partners or stockholders have the funds necessary to buy out the disabled person's interest? Further, if the partner or stockholder has incurred debt on behalf of the business, how is this to be paid off? When dealing with the disability of a partner or stockholder, there are two main items to address. The first involves a salary continuation plan which would continue the salary of the disabled person. The second involves a buy-sell agreement which would cover the purchase and sale of the disabled owner's interest in the event that such disability continues for a period of time.
Salary Continuation Plan
Characteristics Let us first discuss the characteristics of a salary continuation plan. This plan provides protection for an owner/employee from loss of income due to the inability to work because of sickness or personal injury. In addition to the option of covering one or more employees, the business also has the option of whether or not to insure the plan. A qualified formal wage continuation plan, recognized as such by the IRS, contains certain tax advantages. If a wage continuation plan is funded by individual disability income policies, where the premium payor is the employee, the benefits are payable to the employee. If the policyowner is the employee, the premiums will not be deductible. However, the benefits received are income tax-free. In a situation where the premium payor is both the employer and the employee with the benefits payable to the employee and the policyowner being the employee, the premiums contributed by the employer would be deductible and the employer's contribution would be excluded from the employee's taxable income. The benefits attributed to the employee's paid portion would be received tax-free, whereas the benefits attributed to the employer's paid portion would be reportable as income to the employee with the possibility of a tax credit of 15% of the base amount depending upon the adjusted gross income of the disabled employee, whether the disability is total and permanent, and whether the employee is retired on disability. Such a plan should be set up solely for employees. An employee of a corporation who is also stockholder of the corporation is treated as an employee. Any benefits paid under a plan to a
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partner or a sole proprietor will not qualify for favorable tax treatment because they are not considered to be employees. It is important to note that different classes of employees may have different disability benefits. Therefore, it is possible to discriminate and only provide coverage for stockholder/employees if they can be separated from other employees on a basis other than that they are simply stockholders. Another basic requirement of a qualified plan is that it should be in writing and communicated to the employees. In order to be qualified, the plan must also be in effect prior to an employee's disability. In addition, plan benefits should not be excessive when the employee's salary and other compensation is taken into account.
Disability Buy-Out Plan
Description Another question is, can the business continue to pay the disabled employee's salary while he or she is disabled? It would be preferable to provide benefits through disability income insurance, than to have to create a side fund or take money from working capital. In addition, the term "disability" should be defined. Through the use of disability income insurance, the contract will supply a workable definition of disability and an independent third party to decide whether or not an employee is entitled to benefits under the plan. The various definitions of disability available have already been mentioned from "own occupation" to "any occupation". Many policies use the following definition: "benefits will be payable for the first two years if the individual is not able to work at his or her own occupation or profession, and thereafter, if he or she is unable to work in any gainful occupation for which he or she is or may become reasonably fitted by education, training, or experience having due regard for the nature of his or her previous occupation and for his or her previous average earnings." Although it was mentioned earlier that a sole proprietor or partner is not considered an employee for salary continuation plan purposes, it is possible for the business to purchase a disability income policy with income benefits payable directly to the sole proprietor or partner. The rules applicable to personally owned disability income insurance in this case would apply. The premiums would not be deductible, but the benefits would be income tax-free. It is important to remember that where there is no disability income insurance, a sole proprietor merely continues to include the net profits of the proprietorship in his taxable income. If a partner in a partnership receives guaranteed salary continuation payments during a period of disability, these payments are regarded as ordinary income because they are a distribution of the partner's share of taxable income of the partnership. Having discussed the salary continuation plan, let us again consider the following question. What would happen to any partnership or closely-held corporation if one of the owners were to become totally disabled? The answer to this is that financial hardship and confusion would result to both the disabled and healthy partners. Furthermore, what are some of the problems which could be encountered? Will banks cut back credit? Will creditors demand payment? Will clients or customers go elsewhere? Any forced liquidation could be disastrous for a firm because they will receive only $0.25 to $0.50 on the dollar for the value of their assets and there will be a loss of goodwill. The solution to these questions and problems involves the purchase of a disability buy-out plan which:
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§ Provides guaranteed payments to the disabled partner or stockholder; § Guarantees a fair price for the business interest; and § Prevents forced liquidation.
Timeline Another important consideration is how long a business can afford to meet the cost requirements of a nonproductive (disabled) shareholder before it is necessary for the business to replace that disabled individual with a productive one. The active owners will need to ensure orderly control and management of their business operation and will not want to deal with an unsophisticated or uninformed spouse or a court appointed guardian of the disabled person. It is important to determine the length of time that a business can, or desires to, carry a disabled shareholder. The plan then becomes operable at the end of that period, regardless of whether the disabled stockholder can, or will, recover sometime after the pre-determined trigger date. The disability to be insured against is one which lasts a defined period of time, after which the business cannot afford, nor justify, the expense of supporting a nonproductive shareholder. When a salary continuation plan is included as part of a disability buy-sell arrangement, the same definition of disability that is used to activate the salary continuation provision will normally be used to activate the buy-sell provision. A disability buy-sell agreement may be prepared as a separate document or the necessary provisions may be included in the buy-sell agreement applicable to the disability of the business owner. It is important that the definition in the policy is in keeping with the objectives of the parties involved. In most cases, it is best to also include the same definition of disability as that which is contained in the disability income contract used to fund the agreement. The elimination period and the trigger date are two very important considerations of a buy-sell agreement. We know that the elimination period in a disability policy is that amount of time which must elapse, following the inception of disability due to either sickness or accident, before benefits will become payable. The question arises in a disability buy-sell agreement as to how long the elimination period should be and when the buy-sell agreement should be triggered. In other words, when would the disabled partner or stockholder be obligated to sell his or her interest in the business? We must take a look at the statistics to determine after what period of time a disability is most likely to be total and permanent. What we would like to avoid is the triggering of the buy-sell agreement, rather than not having the disabled party have enough time to recover from his or her disability and be able to continue working. There will always be situations where a person, although disabled for a long period of time, may recover from his or her disability and resume normal work responsibilities. The problem, as noted earlier, is that even if this is the case, the business may not be able to continue operation while the person is disabled. Both parties involved in the buy-out must agree that after a disability has lasted for a certain period of time, it will be presumed that such disability will continue into the future. Therefore, these parties must agree that if any one of them does indeed suffer a disability for such a period of time, the disabled party will be willing to sell his or her share of the business interest for the good of the business (and for their own good). It is interesting to note that the probability of recovery after one full year of disability for an individual age 35 is 34%, declining to 11% by age 55.
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Additionally, you will find that most insurance companies will not utilize an elimination period of less than 12 months. It is important to have a salary continuation plan in effect which would cover the loss of income to the disabled worker during the elimination period of the disability buy-out but which would not force a premature trigger of the buy-out. Useful criteria for reaching a decision as to the trigger date includes the importance to the business of personal services performed by the owner/employee, the difficulty of finding a replacement, the skill involved in carrying out their functions in the business, the inter-personal relationships involved, and the ages of the individuals involved. The most popular period of time before a buy-out becomes mandatory is two years. You will find, therefore, that most disability income policies designed for funding a disability buy-sell agreement will have a two-year waiting period.
Types of Disability Buy-Out Plans
Entity Purchase or Cross-Purchase Plan As with life insurance, buy-out agreements, there are two types of disability buy-out agreements - an entity purchase or a cross-purchase plan. Under the entity plan, the business is the owner of, pays the premiums for, and receives the benefits from the policy. The business is also obligated to buy, from the disabled person, his or her share of the business after that person has been totally disabled following a specified period as spelled out in the buy-sell agreement. Therefore, the business would own a policy on each partner or stockholder. The second form of agreement is the cross-purchase plan. This involves a situation where the remaining non-disabled shareholders or partners will buy-out the totally disabled shareholder or partner. In this instance, disability income insurance used to fund the purchase should be owned and paid for by the shareholders/partners on the lives of one another. The non-disabled partners or shareholders will receive the benefit from the policy in order to buy-out the disabled partner/shareholder after he or she has been totally disabled for the period of time specified in the buy-sell agreement. The number of policies needed for this arrangement may become quite cumbersome. For instance, in the case of five partners, each partner would own a disability income policy for each of the other four partners, resulting in twenty policies to cover the agreement. Obviously, this could be quite expensive. Under either type of plan, premiums are not deductible by either the business or the individuals and, therefore, the benefits are received income tax-free. The proceeds received for the sale of a partnership interest are usually divided into two portions. The partner's capital interest is considered a capital asset and the amount in excess of (or below) the seller's basis is a capital gain (or loss). The remaining portion is allocated to receivables and inventory appreciation. This is reportable as ordinary income. If the partnership agreement calls for a payment with respect to goodwill, it is considered part of the capital assets. However, if the agreement is silent about goodwill, the Internal Revenue Service can be expected to attribute a portion of the price (for goodwill) as ordinary income. This brings up another question concerning the payment options available pursuant to a disability buy-sell agreement. There are two methods: lump-sum and installment. A primary advantage of the lump-sum method is that the disabled person receives the entire amount of his or her business
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interest immediately. Based upon the disabled person's financial situation at that point in time, a significantly large portion of the amount received could be subject to taxation. The installment method allows for the spreading of income over a period of years which could significantly reduce any tax liability. This is especially significant for a disability buy-out because the disabled seller is likely to be in a sharply reduced income tax bracket for a number of years following his or her disability.
Method of Arriving at the Purchase Price
Specific Price Method Under a disability buy-out plan, the method of arriving at the purchase price and the date upon which the valuation will be made are the same as those applicable to a buy-out at death. The most appropriate method of arriving at the purchase price involves the "fixed" or specified price method. A fixed price may be utilized with a provision for re-establishing that fixed price at various intervals in the future (such as every year). Advantages of the fixed price method include:
§ There are no misunderstandings as to the purchase price. § The disabled person knows exactly what he or she will receive. § The non-disabled person knows how much insurance is needed. § The contract terms are simplified.
Fixed Price Method The disadvantages of the fixed price method include the need for rather frequent revisions (most often two years) and the possibility that, during revisions, negotiations as to the value of the business may cause disagreement.
Valuation Formula The valuation formula is the most preferred method since it more accurately reflects the value of the business. It should also be written in the clearest possible terms. Consultation with an accountant in determining a formula is highly recommended. Specific valuation concepts, as well as underwriting rules, are provided by the companies which issue disability income insurance to fund buy-sell agreements. Examples of formulas used include:
§ assets minus liabilities, § a multiple of the business's net income after taxes, or § one times the individual owner's salary plus his/her proportionate share of the
tangible assets and accounts receivable.
Remission and Returns to Work At this point, one wonders what would happen if a person suffering from a disabling injury or disease experiences a remission and returns to work for a period of time, but then experiences permanent and total disability again? Would this prevent the individual from being able to
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receive the benefits under a disability income policy? We find that most policies allow for gaps to exist between disability periods, provided that these periods are separated by no more than six months and that the disability periods are a result of the same related causes. Therefore, depending upon the length of time the person has returned to work, he or she would or would not be eligible for benefits under the policy. If a disability buy-out agreement states that the agreement is triggered after twelve months of continuous disability, and assuming our previous scenario of being disabled, returning to work, and being disabled again, the disabled person may be able to collect from their disability income policy, but the buy-sell agreement would not be triggered since the provision for twelve months of continuous disability has not been satisfied. Therefore, the terms of the buy-sell agreement and the terms of the insurance policy used to fund the purchase obligation should be identical to avoid any delay in the trigger date. There should also be a provision in the buy-sell agreement which states that once a disability buy-out is completed, the disabled insured would be allowed to purchase any life insurance policy on his life for an amount equal to its interpolated terminal reserve, plus any dividends on deposit, plus the portion of any premium paid but not yet earned, less any loans outstanding. Once the disability buy-out has been completed, any life insurance that was purchased to fund a debt buy-out will no longer be needed.
Provisions The agreement should also provide for the possibility of the disabled owner dying prior to the receipt of full payment for his/her interest. It may be appropriate to provide that the unpaid balance on the purchase will be payable in a single sum from death proceeds where the agreement is also funded with life insurance. Where there is no life insurance, it may be appropriate to provide that any unpaid installments due after the death of the disabled owner will be reduced in amount with the balance paid out over a longer period of time. It is very important to include a provision in the event of recovery of the disabled owner after the buy-out has started. Generally, the provision states that the disabled owner may not come back into the business once the buy-out has begun, even if he/she does recover. However, this can be changed since one of the typical agreements that we find in a buy-sell contract is the provision which allows the authorization or amendment of the contract at any time, if agreeable to all parties involved. At the end of this chapter you will find a sample buy-sell agreement for a partnership entity purchase. This agreement is only a sample to allow you to become familiar with common clauses typically found in a buy-sell agreement. It is important to remember that the buy-sell agreement should always be drawn up by a competent attorney who specializes in this area. As mentioned earlier, in many cases the disability buy-sell agreement is combined with a life insurance buy-sell agreement. This is the most appropriate way of handling both the life and health risk exposures which face a business today.
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Probability of Long-Term Disability - Tables
The Probability of at Least One Long-Term Disability Out of a Group of Men
The Probability of at Least One Long-Term Disability Out of a Group of Men Number of Men In the Group
AGE 1 2 3 4 5 6 25 47.2 72.1 85.3 92.2 95.9 97.8 30 45.8 70.6 84.1 91.4 95.3 97.5 35 44.0 68.6 82.4 90.2 94.5 96.9 40 41.5 65.8 80.0 88.3 93.2 96.0 45 38.2 61.8 76.4 85.4 91.0 94.4 50 33.7 56.0 70.9 80.7 87.2 91.5 55 27.3 47.1 61.6 72.1 79.7 85.2 60 17.2 31.5 43.3 53.1 61.2 67.9
The Probability of at Least One Long-Term Disability Out of a Group of Women
The Probability of at Least One Long-Term Disability Out of a Group of Women Number of Women In the Group
AGE 1 2 3 4 5 6 25 57.1 81.6 92.1 96.6 98.5 99.4 30 55.1 79.8 90.9 95.9 98.2 99.2 35 52.0 77.0 89.0 94.7 97.5 98.8 40 47.6 72.6 85.6 92.5 96.1 97.9 45 41.9 66.2 80.3 88.6 93.4 96.1 50 34.6 57.3 72.1 81.8 88.1 92.2 55 25.8 44.9 59.1 69.7 77.5 83.3 60 14.7 27.2 37.9 47.1 54.8 61.5
Duration of Disability - Three Months or Longer
The Average Duration of a Disability Which Lasts 3 Months or Longer
AGE MALE FEMALE 25 2.2 Years 2.9 Years 30 2.2 Years 2.9 Years 35 2.2 Years 2.8 Years 40 2.2 Years 2.5 Years 45 2.2 Years 2.4 Years 50 2.3 Years 2.4 Years 55 2.4 Years 2.2 Years
Source: Commissioners Disability Table
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The Probability of One or More Disabilities Lasting at Least 90 Days in the Next 20 Years
Probability
Chances of Disability in a Group of Men:
Number in Group
Average Age 1 Disability 2 Disability
10 35 95.4% 78.8% 10 45 99.2% 94.2% 20 35 99.8% 98.3% 20 45 99.99% 99.91%
The Probability of One or More Disabilities
Lasting at Least 90 Days in the Next 20 Years Probability
Chances of Disability in a Group of Women:
Number in Group
Average Age 1 Disability 2 Disability
10 35 99.1% 93.8% 10 45 99.6% 96.4% 20 35 99.99% 99.90% 20 45 99.99% 99.97%
The Probability of One or More Disabilities
Lasting Two or More Years in the Next 20 Years
Chances of a Two-Year Disability in a Group of Men
Number in Group
Average Age Probability
10 35 25.3% 10 45 49.2% 20 35 44.1% 20 45 74.2%
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The Probability of One or More Disabilities Lasting Two or More Years in the Next 20 Years
Chances of a Two-Year Disability in a Group of Women:
Number in Group
Average Age Probability
10 35 47.9% 10 45 54.9% 20 35 72.9% 20 45 79.6%
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Sample Agreement
Articles ARTICLE I In the event that any Partner party to this Agreement shall become totally disabled for a continuous period of ________ months, the disabled Partner shall sell and the Partnership shall buy all of the disabled Partner's interest in the Partnership then owned by the disabled Partner for the price specified in or determined under Article III. The price is to be determined as of the date the Partner is first deemed "Totally Disabled". ARTICLE II - Total Disability Defined "Total Disability" shall have the same meaning as contained in the ABC disability buy-sell insurance policy owned by the partnership for purposes of funding this Agreement. A Partner shall be deemed to be "Totally Disabled" for the purpose of this Agreement if the ABC Life Insurance Company determines that a Partner is Totally Disabled as defined within their policy. ARTICLE III - Valuation of Partnership The Partners and the Partnership agree that the present value of the Partnership's capital assets is $______, that the fair value of unrealized receivables is $_____, that the fair market value of the inventory is $______, that the value of goodwill is $______, and that the value of each Partner's interest is as follows: Partner Ownership Interest ______________________ _______________________ ______________________ _______________________ Each year the Partners and Partnership shall agree upon the value of the Partnership. The agreement shall be put in writing, signed by the Partnership and Partners, and thereafter beattached to this disability buy-sell Agreement. The value in the attached Agreement will be considered as the current purchase price for the Partnership. If the Partnership and the Partners fail to agree upon a modified value for a particular year, the last agreed upon value shall control. If the Partnership and the Partners fail to modify the value of the Partnership for two consecutive years, the value shall be agreed upon by the selling Partner and the Partnership. If an agreement cannot be reached within 30 days the selling Partner and the Partnership may choose a qualified independent arbitrator to determine the value. This decision shall be binding upon the parties. The compensation for the arbitrator's services will be borne equally by the selling Partner and the partnership.
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ARTICLE IV - Rights and Liabilities of Partner Before Transfer A partner shall retain all of the rights and liabilities owned by him prior to the date the first payment of the purchase price has been paid. Upon such date the ownership interest of the selling Partner shall be transferred to the Partnership. ARTICLE V - Purchase of Partnership Interest (Installment or Lump-Sum) In the event of a sale of a Partner's ownership interest in the Partnership by reason of total disability of a Partner, the purchase price shall be paid in equal consecutive monthly installments (or in one lump-sum payment). In the event of a sale by reason of total disability of a Partner, the first installment shall be paid no later than 6 months after the end of ____ months of total disability and shall continue over a period of ______ month(s). The proceeds of the ABC disability buy-sell insurance policy owned by the Partnership on the life of a disabled Partner shall be applied to the payment of the purchase price, the proceeds of any life insurance policy or policies on such partner's life shall then be applied to pay the balance of the outstanding payments. The payment of the purchase price shall be evidenced by a negotiable promissory note executed by the Partnership or the purchasing Partners, as the case may be, to the Partner himself in the event of a lifetime sale with interest at ______ percent compounded annually. In the event of default in the payment of principal or interest for a period of 10 days, the balance remaining to be paid under such note shall, without further notice, immediately become due and payable at the election of a holder. Said note shall include the following provisions: 1. Said note shall provide that its maker agrees to pay the reasonable expenses of collection in the event of default, including reasonable attorney's fees. 2. Said note shall provide that its maker has the option of prepayment in whole or in part at any time without penalty. 3. Said note will be secured in a manner that is acceptable to all the parties to this agreement. In the event that the proceeds of any insurance owned by the Partnership and made part of this Agreement exceed the purchase price, any excess shall be retained by the Partnership. ARTICLE VI - Funding of Agreement In order to effectuate this Agreement, the Partnership shall apply for and be designated as owner and beneficiary of the disability buy-sell policies on the lives of the Partners. The Partnership may purchase additional insurance on the life of the Partner for purposes of funding its obligations under this Agreement. The insured Partner agrees to do all things necessary to enable the Partnership to obtain this additional insurance.
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ARTICLE VII - Partner's Right to Purchase Life Insurance Upon the completion of all payments due under a disability buy-out pursuant to Article III, the disabled seller shall then have the right to purchase any insurance policies on his life owned by the Partnership, by paying an amount equal to the cash surrender value of such policy as of the date of its sale, plus the unearned portion of any premium paid on the policy. The right to purchase the policy shall lapse if not exercised within 90 days after such sale or termination. ARTICLE VIII - Payments of Purchase Price After Selling Partner's Death If the selling Partner should die after the commencement of payments under the installment period, it is understood by the Partners and the Partnership that the disability buy-sell insurance policy funding this agreement will not continue to provide benefits for the purchase of the selling Partner's ownership interest. The life insurance policy still owned by the Partner on the life of the selling Partner shall be used to make the remaining payments. ARTICLE IX - ABC's Liability The ABC Insurance Company which has issued a policy subject to this Agreement shall not be under any obligation with respect to the performance of the terms and conditions of the Agreement and shall be bound only to the terms of the policy which it has issued or shall hereafter issue and shall have no liability except as set forth in its policies. ARTICLE X - Amendments This Agreement may be altered or amended by written agreement. ARTICLE XI - Authorization and Effect The parties to this Agreement or their duly authorized representatives shall make, execute, and deliver any documents necessary to carry out the provisions of the Agreement. This Agreement shall be binding upon the Partnership, the Partners, their heirs, legal representatives, successors, and assigns. ARTICLE XII - Termination This Agreement shall terminate upon the following occurrences: (a) Cessation of the Partnership's business; (b) Bankruptcy, receivership, or dissolution of the Partnership; (c) Whenever there remains only one Partner bound by the terms of this Agreement; (d) The written Agreement of all the parties who are bound by this Agreement; (e) At the option of a Partner, if the Partnership allows the insurance policies funding this
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Agreement to terminate due to nonpayment of premium; (f) Death of all Partners, simultaneously or within a period of ______ days. ARTICLE XIII - State Law Governing This Agreement shall be subject to and governed by the laws of __________. In Witness Whereof, the Partnership and Partners have hereunto set their hands and seals of this ______ day of _______, 19___. _______________________ Partnership Partners Ownership Interest _______________________ ________________________ _______________________ ________________________
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Chapter 5 Objectives Upon completion of this section, you will:
§ Gain increased knowledge of business overhead risks and solutions to offset risk. § Discover what happens when a professional becomes disabled. § Be better informed for clients on the tax issues specific to business overhead insurance.
Chapter 5 Business Overhead Expense Insurance
When the Professional Person Becomes Disabled
Business Overhead Expense Insurance Business overhead expense insurance is a relatively recent development which allows disabled professionals, proprietors, and in some instances, partners, to pay office expenses such as rent, utilities, and employee salaries for specified periods of time (usually a maximum of twenty-four months). The majority of professional individuals accept that if they should become disabled, their period of disability will be short and will not involve a long absence from work. In addition, if the professional person does become disabled, his or her initial reaction is to keep their office doors "open for business", since they will be returning to work in a short time. However, these individuals will still be responsible for the overhead expenses of the business, which continue no matter how long the disability lasts. Who will pay the rent, electricity, water, and telephone expenses? How will the heating, cleaning, and laundry bills be paid? How will the employees' salaries be paid during this period of time? Who will pay for any of the fixed expenses which are customary and normal in a business office setting?
Evolution
History The Business Overhead Expense (BOE) contract began to evolve in the 1960s and expanded during the 1970s. However, it has yet to reach its full market potential, much like the disability income business in general. In recent years, a myriad of insurance companies have offered a business overhead expense policy for professional people. The purpose of this type of contract is not to replace the income of the professional. That particular risk can be protected by individual
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or group disability income contracts which are designed to replace earned income when an insured becomes disabled. The main function of a BOE policy is to provide an apparatus for paying the business expenses which continue while the owner of the business is disabled. As noted earlier, the business overhead expense market has yet to reach full potential. Professional individuals comprise an important and rewarding market for disability income insurance. There are a multitude of professionals situated in the work place and most of them earn above average to large incomes. Because of this, and due to the fact that they have had extensive training and are involved in a personal service type of work, professional individuals are more susceptible to a financially destructive disability. The degree of disability to which they are exposed need not be permanent. A short-term disability can be just as devastating. Not only would this individual lose his or her earned income for that period of time, but there is also the danger that he or she would lose customers depending upon the business involved. For example, if a dentist in a sole proprietorship becomes disabled for three or four months due to injuries sustained as a result of an automobile accident, several potential problems must be dealt with. First, and most obvious, our dentist's earned income will cease during the period of disability since he/she is unable to work. A further danger exists since this dentist is a sole proprietor. If he/she is unable to perform the duties of his/her occupation for three or four months, where are his/her patients going to go for treatment? If patients need emergency dental treatment, where will they go? The obvious answer is that his/her patients will have to seek treatment from another dentist or dental facility. So a disability brings with it the danger of losing customers or, in this case, patients. Due to the disability incurred, the dentist is not able to earn income and it is quite possible that he/she will also lose some patients, the exact number of which will de determined by the length of the disability. Another problem to be dealt with involves the expenses such as rent, utilities, employees' salaries, etc. which will continue even though the dentist is not able to practice dentistry. How can the secretary, dental assistant, or hygienist be paid if there is no money coming in?
Insured Markets Who are the professionals that have a need for a business overhead policy? As previously mentioned, professionals are most susceptible to the disability risk because of their incomes, extensive training, and the services they provide. "Professional people" is a description which covers a broad range of occupational pursuits. However, it is not really difficult to identify or pinpoint these individuals. Included in the "professional" realm are physicians (surgeons and general practitioners), attorneys, dentists, accountants, engineers, architects, educators, and many others. Professions such as these require extensive study in highly specialized fields and also involve a tremendous investment of one's time, effort, and money. Several of these professions require years of study before one can begin to reap economic and professional rewards. Even after a considerable amount of time is spent becoming a "professional", it takes a considerable amount of time to become established. A professional may be salaried or self-employed. Salaried professionals are those who are employed by large corporations, law firms, or government agencies, for instance. Although the
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risk of disability is present for either a salaried or self-employed professional, it is the latter who faces the additional exposure of what to do about business overhead expenses. The self-employed professional has a definite need for not only personal disability income insurance, but overhead expense insurance as well. These individuals are independent business people with highly specialized skills. Since they are involved in unique and distinct situations, they also have a definite need for complete disability income protection due to the tremendous investment (time, education and training) each has made in themselves. An individual who wishes to become a physician will spend time achieving an undergraduate degree. Then he or she proceeds to medical school for several years which, in turn, leads to a residency, and so forth. This individual will most likely be well rewarded for his or her efforts. In addition, their earnings will be directly related to the expertise and practice they have developed. Such a self-employed physician will remain independent and secure for as long as he or she is able to work and earn an income. The fact that this physician could become disabled and receive no income cannot be ignored. This is one of the features that make the self-employed professional (or sole proprietor) more of a risk than the normal business person. When disabled, the money will cease to come in, but the physician's personal and business expenses continue. A large part of earned income was used to pay these expenses. It has been mentioned that when income ceases, business expenses continue, and the professional may lose customers if he/she becomes disabled, even for a short period of time. But, there are also other considerations. This physician may lose valuable employees if the office must close. He/she may have to cease contributing to his/her own retirement program(s). He/she may have to dip into his savings or emergency funds. Education program contributions will be stopped and it is conceivable that if his or her children are enrolled in college, they may have to withdraw. These are just samples of the many areas which would be affected by the self-employed professional's inability to earn an income due to a disability. The business is not the sole entity affected. Obviously, most professionals see the need for an individual or group disability income plan. Many do not look into, or are even aware of, disability income protection to pay for their ongoing business expenses while they are disabled.
Disability Most self-employed professionals, as well as almost everyone, feel that if they became disabled, it would only be for a short period of time. Others connect the term "disability" with a permanent state and, of course, feel that it could never happen to them. Business overhead expense insurance is available to self-employed professionals. Some insurers, who wish to target a specific group of professionals, have begun to write Professional Overhead Expense (POE) insurance which, in essence, provides the same coverage as the BOE policy. Will any self- employed professional qualify for business overhead coverage? Not always. This type of protection is offered on the basis that the professional's business will cease or be seriously endangered if a disability occurs. Actually, in many cases, the proposed insured must provide proof to the insurer that his physical presence is essential in order for the business to continue operating. In other words, it must be demonstrated to the insurance company that the self-employed professional in question is indispensable to his or her business.
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Reimbursement of Expenses A business overhead expense contract provides reimbursement to the insured professional for the actual business expenses incurred. The majority of policies provide this protection up to specified limits while the insured is disabled. In addition, there is generally a waiting (elimination) period which must be satisfied before benefits begin. This "waiting" or "elimination" period functions in the same manner in a BOE contract as it does in an individual or group disability income policy. These waiting periods are typically 30, 60, 90, or 120 days. Of course, the longer the waiting period, the less the premium. The policy will reimburse the insured for such expenses as rent, utilities, taxes, employees' salaries, insurance premiums (in some cases malpractice premiums), and many others. The disability must also be one which prevents the insured from performing the duties of his or her professional occupation. In addition, the insured must be under the care of a physician. This latter point is required of anyone insured by any type of disability income contract. BOE policies are usually written to pay the covered business overhead expenses for a maximum period of one or two years. This benefit period, although limited, is usually sufficient since the self-employed professional who suffers a disability will know by the time benefits expire whether or not he/she will have to shut down their office. BOE coverage is issued to those professionals who are either involved in an independent practice, in a partnership practice, or in a professional corporation. However, this form of protection is not usually available to participants in partnerships or professional corporations with more than ten practicing professionals. More recently, many companies have refused to write BOE coverage if there are three or more partners. In these situations, the business conducted by the healthy associates (co-professionals) is viewed to be sufficient to meet overhead expenses. Premium Costs The cost of business overhead expense insurance is not high. In fact, premiums are comparatively low due to the type of coverage offered and the limited benefit period involved. These premiums are much lower than those charged for an individual disability income policy and are also tax deductible. This last point will be discussed in more detail later.
Benefit Limitations and Exclusions A limit is also placed upon the amount of monthly expenses (benefits) which a company will insure, such as $10,000. Some companies may even provide up to $25,000 of coverage. Special applications are usually required which itemize the professional's business expenses. The underwriting department then analyzes each of these expenses to determine if they are reasonable and appropriate. In addition, a policy which provides $5,000 of coverage to an insured will not necessarily pay that amount when the insured becomes disabled. For example, a CPA may purchase a BOE policy providing $5,000 of monthly coverage. However, when he or she is disabled, and following the waiting period, the insurer determines that the insured does not have $10,000 worth of monthly expenses. Ideally, this discrepancy should be discovered during
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the underwriting process. But even if the insured secures coverage for a specified amount, he or she may not collect it if business expenses at the time of disability are less than the specific amount secured. Furthermore, these policies may contain significant exclusions. Variable costs, such as goods and supplies, generally are not covered. Wares, merchandise, or implements are also excluded. The costs of items such as fees, salaries, drawing accounts, or other remuneration of the insured professional are excluded as well. In addition, the costs of salary paid to an individual (key employee) who fills in for a disabled owner may not be covered either. Remember that a requirement of many BOE policies centers on the fact that it must be demonstrated to the insurance company that the insured's physical presence is necessary for the business to continue operating. If the owner (the self-employed professional) can, while he/she is disabled, have the business run by a key employee, the salary paid to this key person will certainly not qualify as a covered expense. Further, a retail business offers a unique challenge for business overhead expense because the disability incurred by the owner may not greatly affect the income of the concern, especially short-term. The retail employees will continue to produce income for the business even in the event that the owner is disabled. In a situation such as this, if underwritten by an insurer, the coverage offered may be only a percentage of the total expenses of the business. For instance, an insurer, when dealing with an application from a retail business, may only allow coverage for 70% or 75% of the total business expenses. In the case of large retail chains, insurers have been known to offer as little as 50% of the total expenses for business overhead protection. These companies subscribe to the theory that the greater the number of employees, the less the need for business overhead expense coverage. In situations where the normal level of business income continues to be generated during disability, there is no need for BOE coverage.
Benefit Duration While limits are placed upon the amount of monthly benefits available, similarly, there is a limit on the duration of the benefits. Reimbursement may be limited to one year or some other stated period (usually 18 or 24 months). Thus, business overhead expense insurance is not designed for long-term overhead obligations.
Comparison with Individual Policies In contrast to individual disability income policies, a business overhead expense contract is written on a reimbursement basis. This means that at the time of a claim, the specific amount paid is based upon the exact expenses incurred. With an individual disability income contract, whether of a personal or group nature, benefits (claim payments) are paid on a flat monthly indemnity basis. In other words, whatever the monthly benefit amount applied for is what the insured will receive when he or she becomes disabled. Remember that BOE claim payments are based on actual incurred expenses.
Tax Aspects It was previously noted that the premiums paid for a business overhead expense insurance policy are tax deductible. This is due to the fact that these premiums may be classified, according to the Internal Revenue Service, as a legitimate, ordinary, and necessary business expense. These
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premiums are deductible whether paid by a proprietor, partnership, or corporation. The same is true when an insured qualifies for such coverage as a self-employed professional. We know that the premiums paid for BOE policies are deductible. But what about the benefits received when the insured becomes disabled? The claim payments or benefits received from such policies are taxable income to the insured. However, even though these benefits are taxable, there exists an offsetting feature in the business expense deductions which may be taken for actual overhead expenses incurred. Therefore, for every dollar of benefits received from business overhead expense insurance, there will be a dollar of business expenses to deduct, including such expenses as rent, utilities, and employees' salaries. The tax treatment of business overhead expense contracts differs from individual disability income policies since premiums paid by an insured toward an individual plan are not tax deductible, but the benefits are received tax-free.
Summing It Up Business overhead expense insurance is a fairly recent development which presents the self-employed professional with a vehicle to allow his or her business to continue in the event of disability. Although it has not yet reached its full potential in the disability marketplace, it is the type of coverage intended for individuals whose professional or business income will drop dramatically if they become disabled because their personal involvement and presence is necessary for the business to function smoothly and efficiently. It also provides a professional person the opportunity to purchase additional disability income coverage in the event that he or she has purchased the maximum amount of individual disability income allowed. This flexibility can be of paramount importance to the high income professional person who may have difficulty in qualifying for enough disability income insurance.
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Unit THREE Annuities
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Course Description Course Overview and Objectives
This section explores and details the different types of products and situations involving annuities along with their many uses when it comes to providing for individual, family, and business needs. The annuity section profiles the annuity concept and details as well as explains what an annuity is and how it works. The fundamentals of the accumulation and payout phases of annuities are discussed. Settlement options are explained along with their most common uses being covered. This section also discusses taxation of annuities. Federal income tax treatment of premature withdrawals, lump-sum distributions, and periodic payments are dealt with fully. It covers the different types of annuity contracts and the characteristics of each of the fixed, variable and equity indexed varieties. Annuity product types with their features and benefits are highlighted including specifics such as premium options, immediate vs. deferred, qualified vs. nonqualified, and the whole host of settlement options.
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Chapter 1 Objectives Upon completion of this section, you will:
§ Gain increased awareness of the different basic structure and characteristics of annuities. § Be better equipped to inform clients about phases, options, riders, and penalties. § Know more about ways for taking money out of annuities and considerations involved. § Examine and be able to inform clients about the varied specific types of annuities.
Chapter 1 Annuities Basics
Annuity Overview
Introduction This section was designed, constructed and written to provide you with continuing education in the area of Annuities with special attention to the various types and issues specific to the world of accumulation through annuities. It acknowledges and includes examination of Fixed, Variable, CD Type, Bond Index, Single Premium, Equity Indexed, Tax Sheltered, Market Adjusted, and Impaired Risk annuity categories due to the many types available in the marketplace. It also highlights distribution opportunities and tax consequences for withdrawals that are a fundamental component of annuity accumulation programs. Besides the goal of acquiring additional credits toward your continuing education requirement, it is our hope that you will acquire a new level of competency and insight into this highly critical area of people’s financial future…saving and accumulating dollars for use in the future. As time goes by, individuals’ situations change with respect to their available discretionary income, tax brackets, and family situations. In addition, tax law changes, program availability, and feature modifications are constantly being reviewed, updated, and changed. Some save specifically for retirement and education. Some save for the future (retirement) exclusively, and take care of education as best they can when it occurs prior to their retirement…or some combination of both! Yet some things are fundamental and seldom, if ever, change. Accumulating funds for the future depends on money, time, a vehicle, and consistency. With so many plans and places to save or
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invest in, the real key is to start putting aside funds so that an educational nest egg is available down the road. The more one puts away today, the more it grows. The higher yield or growth each dollar earns makes it compound faster and greater. The fewer taxes we pay when we put it away, as it grows, and when we take it out allows for each dollar to work harder, grow larger, and provide for more of its intended usage. And, to the extent we have planned ahead for certain amounts to be available at specific times in the future, the more motivated we are to put aside on a regular basis an amount that will grow to what is needed in the future (consistency). Your annuity study section is comprised of 6 chapters with additional pages of charts, graphs, and other visual tools for enhancing the value of the information for you as well as to enhance your recall beyond this course. There are chapter review questions included at the end of each chapter to improve your retention of key elements as well as to confirm your mastery of the material content. An answer key for the chapter review questions is included in the back of the book for checking your answers’ accuracy. Whether you are a newer agent or a veteran, we’re confident that you will gain new insight into this critical area for Americans as well as brush up on current info and regulations pertinent to this area of your expertise.
Background Before getting into the specifics of the many and varied types of annuities in specific, we want to take an overall look at the subject of annuities, in general. This will set the stage for further discussion and insight into the varying types and special aspects of different approaches in creating earnings and interest on money to be set aside in annuities. In looking ahead to their retirement years, many individuals plan on Social Security and pension plans from their employers to provide needed income and funds for their retirement. However, these many times only provide for a small portion of what is needed and desired for income security at retirement. Because of this shortfall, people want to supplement these two areas with additional sources of funds at retirement. The purchase of non-qualified annuities is one way to accomplish this. In addition to retirement saving, many people use annuities to provide an income from the proceeds that they receive lump sum from life insurance policies and from occasional lump sums received from a business venture or a large sum received as bonuses from varied sources.
What is an Annuity? The dictionary defines annuity as “a yearly grant or allowance, or as an investment of money entitling an investor to a series of equal annual sums over a stated period.” It has one basic purpose and that is to provide a series of payments over a period of time. Usually this period of time is over the lifetime of the person who is the annuitant named in the annuity policy. This is a unique feature and is not found in any other investment or accumulation vehicle. It provides a stream of income that the annuitant cannot outlive no matter how long that is. This
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lifetime guarantee of income is also unique as it promises to continue payments even if the payments are continued after all of the annuitant’s accumulation of contributions and earnings are used up. Another important feature of a non-qualified annuity is that, unlike other savings vehicles like savings accounts, CDs, and the like, the growth inside the annuity during the accumulation period is “tax deferred” and not subject to current income taxation for the owner of the annuity policy. This allows for the full amount of the value of the annuity to compound without the diluting effect of current income taxes being siphoned off before the positive effects of time and compounding take effect on the account value. Commercial annuities are the kind written by insurance companies and this is the focus of our course. An annuity is a contract with two parties, the insurance company and the owner of the annuity policy. The policy is a written document that sets forth the terms and conditions of the contract. The applicant or owner pays a sum of money to the insurance company. This might be a single premium or a series of periodic payments. The period of time during which the policyowner’s funds are accumulating at interest is called the accumulation or deferral period. At a specific, predetermined point in time, the insurance company starts paying money back to the owner (annuitant). This is called the payout period. The annuitant has a number of options available for withdrawing the money accumulating in their policy. The will be discussed further on in the text. If a policyowner names a beneficiary of their annuity, any sums of money due and payable at the annuitant’s death will pass directly to the person named and will do so outside of probate.
Qualified or Non-qualified
Qualified Qualified annuities refer to whether the annuity is a part of an employee benefit plan that has met certain requirements, or becomes “qualified” under the Internal Revenue code such as an IRA (Individual Retirement Account) or a TSA (Tax Sheltered Annuity). A qualified annuity is one that is used as a part of or in connection with a qualified retirement plan. Simply put, a qualified retirement plan is one that differs from a non-qualified arrangement in that contributions made into the qualified plan are income tax deductible to the employer and to the account holder in the case of an IRA and TSA.
Non-qualified A non-qualified annuity may be purchased by any individual and is not associated with an employer-sponsored retirement plan or an IRA or TSA. The contributions to a non- qualified annuity are not tax deductible. While “non-qualified” may sound like a negative to some, it has nothing to do with the qualifications of the policy or the company issuing the annuity.
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Immediate or Deferred
Immediate An immediate annuity begins making periodic payments quickly (within one year after purchase) to the annuitant right after the policy is issued. It is usually issued for a single lump sum premium that will give an annuitant and/or their spouse a guaranteed fixed payment. These payments may be monthly, quarterly or annually and based on one's life expectancy or that of the annuitant and their spouse.
Deferred Annuity A deferred annuity is one under which the annuity owner defers or delays receiving payments until a later date. A deferred annuity accumulates at interest for a specific period of time before the company begins making payments to the annuitant. It delays an annuitant’s income stream, accumulating interest without earnings being taxed until withdrawn. People often purchase deferred annuities during their working years in anticipation of the need for retirement income later in their lives. Most deferred annuities provide a great deal of flexibility surrounding the timing and amounts of payout benefits.
Fixed or Variable
Fixed An annuity policy can be fixed or variable. A fixed annuity does not fluctuate in value. The underlying investments are owned by the insurance company as part of its’ general account. The insurance company guarantees the value of each in-force annuity policy that is back by the general assets of the company. Every fixed annuity policy contains an underlying guaranteed minimum credited interest rate. The minimum interest rate during the accumulation period may be different than the minimum interest rate during the payout period. In addition to the guaranteed underlying interest crediting rate, the annuity company usually declares a current interest rate that is higher than the minimum guaranteed rate and it is normally guaranteed for a period of time, generally one year. At the end of this period the company will declare a new current credited rate.
Variable A variable annuity fluctuates in value according to the performance of its investments, which are held by the company in a separate account outside their general accounts. All variable annuities are and must be registered with the Securities and Exchange Commission. The majority of this course deals with fixed annuities, but will also touch on variable, in general, to have a better overall view of the variety and relationship of the various approaches available in the annuity world.
Phases of an Annuity There are three basic phases in the life of an annuity...Contribution, Accumulation, and Distribution. More specifics on each of these key areas will be explored further in this course.
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Contribution Contribution refers to the methods, timing, and amounts of money set aside in the annuity policy. Contributions can be a lump sum as well as periodic payments over time. The threshold of entry is not limited to people of wealth, but many can put aside money for as little as $50 or less on a monthly basis.
Accumulation Accumulation is the time between the contributions and the distribution / payout period. During this period, the annuity builds up and accumulates the funds that will provide the annuitant with the total funds that generate the income stream desired during the distribution phase. The growth during this period is tax deferred and thus allows funds to grow unencumbered and much larger by current income taxation not being applied.
Distribution/Annuitization Distribution/Annuitization refers to the period when the insurance company provides the annuity payments over a specific period of time, or over the annuitant’s lifetime. This is discussed more fully under the settlement options section that follows later on.
Interest rates – Guaranteed and Current In general, companies offer two interest rates on fixed annuities. The guaranteed rate is a minimum rate that the company will credit on the funds in the annuity, regardless what interest rates are available in the overall marketplace. The current rate is a rate of interest that the insurance company credits based on their success with their investment program within their general accounts underlying the company. The current rate is generally revised and changed once a year, but can be adjusted more frequently on some annuities if specified in those annuities.
Premiums - Single or Flexible Single Premium Annuities are what their name implies…a single lump sum paid to an insurance company into an annuity. The annuitant will then let the company know when they want the payments to begin and under what payment option they want it to be paid out. A Flexible Premium Annuity is also what its name applies…varying amounts of payments and varying time intervals between payments. All amounts at those intervals accumulate to build a fund to be available for payments in the future at the direction of the annuitant/owner in line with the various payout options provided by the contract.
Maximum Ages for Issue and Benefits Typically, most companies allow for annuities to be purchased and issued up to the annuitant’s and owner’s ages in the late 80’s to 90. There are, however, others that will set the maximum age of the low 80’s for annuitant and owner categories. For maximum payout ages, there is no age maximum required by the IRS, but most companies set their own age maximum for annuitization at 80 to 85, while others allow a maximum of age
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100. An annuitant should check the contract for these requirements before purchasing one if their need is to have an older age for annuitization and distribution.
Settlement Options Settlement options are the methods by which an insurance company pays annuity policy proceeds to the annuitant, contract owner, or beneficiary. The Distribution Phase of annuities is the fundamental purpose for which the annuity vehicle holds it uniqueness over all other saving and investment vehicles. There are many options, methods, and techniques in this area that provide alternatives to best match the needs and special requirements for the annuitant to maximize their income needs both in amount and time period duration. Annuities offer a variety of options so that annuitants with varied long term income stream needs may tailor their income schedule to suit their needs. They can choose to receive payments, monthly, quarterly, semiannually or annually. The following takes a look at many of the payment options available:
Period Certain Only "Period Certain" means that income payments will be made over the number of years the annuitant chooses. Payments will continue for the duration of the number of years they chose, and then cease. If they should die before the end of the stated number of years, their beneficiary would continue to receive the payments for the remainder of those years.
Life Only This option provides for payments that will continue for the rest of their life. They cannot outlive their income. Upon their death, payments stop.
Life and Period Certain Life and period certain means that payments will continue for the rest of their life, but for no less than the stated number of years. If they should die before the end of the stated number of years, their beneficiary would continue to receive the payments for the remainder of those years.
Life Only with Guaranteed Minimum Option The annuitant receives payments that will continue for the rest of their life. If they should die before they have been repaid their initial investment, the balance of their initial investment will be paid in like installments to their beneficiary.
Joint and Survivor This option provides payments that are guaranteed during the lifetime of two people. After the death of one, payments continue for the lifetime of the surviving person. The annuitant can choose to have either full payments, or a percentage they chose to continue for the lifetime of the survivor. They can also specify a period certain, and if both individuals were to die within the
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period certain, payments would continue to the named beneficiary for the remainder of the period certain.
Surrender / Penalty Charges While many companies vary in how they go about arranging their surrender charges, most follow a decreasing percentage of charge over a number of years. This charge is also referred to as a “deferred sales charge”. Some charge this decreasing percentage each year counting from the issuance date of the annuity contract on the amount of the funds withdrawn or surrendered. This simple format applies typically to single deposit / premium contracts. Others apply the decreasing percentage for the number of years to each deposit that the annuity holder makes into the annuity. This typically applies to flexible premium annuities. Each deposit is subject to it’s own decreasing percentage over the specific number of years and is kept track of by the company and calculated on the amount of the withdrawals and surrenders, both partial and full. An example of a surrender charge schedule might look like the following:
Contract Year Surrender / Withdrawal Charge
1 8% 2 7% 3 6% 4 5% 5 4% 6 3% 7 2% 8 1%
Note: These surrender charges do not reflect the 10% penalty imposed by IRS if withdrawals and surrenders are made prior to age 59½
Death and Disability Most companies include a waiver of the surrender charges if the annuitant dies or becomes disabled. Many companies also allow a portion of the value of the annuity to be withdrawn each year without surrender or withdrawal penalties being imposed.
Nursing Home Waiver Some companies include a special feature to provide additional liquidity without surrender charges. Their annuity contracts offer a waiver of the contract’s surrender charges or withdrawal penalties in the event that the annuitant is either hospitalized or confined to a nursing home for a certain period of time, such as 30 days or longer. This provision allows the owner of the contract to extract funds from the annuity contract that might be needed to meet the expenses or lost income associated with the longer-term hospitalization or confinement. Other annuity contracts allow medically related surrenders that are not subject to the contracts’ surrender charges.
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Generally, there is a requirement that the annuitant be confined in a medical care facility for a certain period of time or be diagnosed with a terminal illness. Although not part of the contract, the IRS 10% premature distribution penalty tax may also be applicable to a withdrawal for this same reason if the person is under age 59½. To avoid the imposition of this penalty, the taxpayer must be able to qualify as being “disabled” based on the definition in the Internal Revenue Code. The code’s definition may differ from the definition used in the annuity contract. In the Internal Revenue Code, for purposes of the 10% premature distribution penalty tax, “disabled” is defined as follows: “being unable to engage in any substantial gainful activity by reason of any medically determinable physical or mental impairment which can be expected to result in death or to be of long-continued and indefinite duration”.
Withdrawals In addition to the partial and full surrenders that we have discussed earlier along with their corresponding surrender charges, contract holders frequently need to access funds for a variety of reasons. Many annuities allow their annuity holders to withdraw up to 10% of their account value each year without the surrender charges applying to these withdrawals. Similarly, other companies allow for withdrawals of the interest in the account or 10% whichever is greater. And, still others allow the 10% withdrawal amounts to accumulate each year to allow for accumulated withdrawals of 20%, 30%, 40%, etc. as time goes by for the annuity owner.
Loans Loans are not generally allowed on annuity contracts. This may be limited by the exclusion of loan provisions by the annuity contract itself. Also, unfavorable taxation arises out of loans from annuities and thus not appropriate especially in light of the fact that there are many partial, full, and surrender-free features that allow for money to be accessed outside of direct loans from the annuity.
Bail Out Some fixed annuities may have a “bail out” provision. This feature allows the annuity owner to cash in their contract without surrender charges if the interest rate credited to their annuity falls below a certain predetermined level. An example of this would be a provision where the bail out rate is specified to be 1% below the current rate being credited. In this case, if the interest rate declared is more than 1% below the current interest rate, the owner of the annuity could surrender the annuity and not have to pay any of the surrender charges that are normally charged for surrender where the interest rate was above the “bail out” rate. This provides a measure of peace of mind for the annuity owner against wanting to move their money in dramatically falling interest rate times, but not being able to do so without incurring significant expenses in order to move their money elsewhere.
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Types of Annuities The following are brief overviews of a variety of the most common annuities available for people wanting to use these vehicles for accumulating funds and income streams for retirement and the future in general. New concepts and hybrids of these existing annuities are constantly evolving and being introduced to the marketplace. The subsequent chapters in this course will delve into each one of these more fully.
Fixed Annuities These are annuities that pay an interest rate which is guaranteed for one or more years and have surrender charges that typically decrease over one or more years. A fixed annuity refers to the interest rate paid by the insurance company on the funds placed in the annuity. When a person purchases a fixed annuity, they know what the current and guaranteed interest rates are and these are the types of interest rates that will be earned on their money as long as the issuing company does not go out of business. Fixed annuities offer security because the rate of return is certain and known up front. The risk for performance falls on the company issuing the annuity and the annuity holder does not have to take on the responsibility for investing the money. In addition, the ‘fixed’ nature of these annuities applies to the amount of the benefit to be paid out during the annuitization period, as well.
Bonus Annuities This is an annuity that usually offers a higher first-year interest rate that is guaranteed for one year. The "base rate" is the interest rate that the company projects it will pay in the second year and thereafter, but is NOT guaranteed in most cases. The difference between the actual rate in the first year and the projected base rate for subsequent years is the “bonus” rate. Quite often, the "renewal rate" a company declares on each contract anniversary from the second year and beyond is different than the projected base rate.
CD Type Annuities This category contains those annuity products where the number of years the interest rate is guaranteed is equal to the number of years the surrender charge exists. For example; annuities products that have a 5-year guaranteed interest rate and a 5-year surrender charge are typically regarded as CD Type annuities.
Bond Index Annuities Bond Index annuities are policies which provide growth and return on funds deposited in them based on the choice of different "Bond Portfolios" or "Bond Strategies" each with its own investment objective. These "portfolios" or "strategies" are modeled after the portfolios of some well-known bond Indexes. Examples of Bond Indexes that companies might use to model their
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portfolios after include Lehman Brothers High Yield Bond Index, Merrill Lynch Convertible Bond Index Total Return, Lehman Brothers Government/Corporate Bond Index, etc.
Equity Index Annuities This is a unique class of annuities that use an equity index as the basis for calculating the interest that will be credited to the annuity policy. These annuities have all the guarantees of a fixed annuity contract plus the potential of stock market returns with no downside risk.
Tax Sheltered Annuities These are annuities that have been designed specifically for use in the Tax-Sheltered Annuity market primarily for teachers and employees of non-profit organizations and associations.
Variable Annuities Variable annuities are annuity products that provide an the option of "mutual funds" referred to as “sub accounts” or “separate accounts” to invest in within the annuity policy in addition to the traditional fixed account.
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Chapter 2 Objectives Upon completion of this section, you will:
§ Gain increased awareness of fixed annuities and their variations. § Discover how the various components and characteristics of annuities affect clients. § Understand the differences between Single, CD type, Equity Index, and Bond Index. § Gain a working knowledge about Index Annuities and talk to clients confidently.
Chapter 2 Fixed Annuities & Variations
Fixed Annuities
What is a Fixed Annuity?
A Fixed Annuity, also referred to as a tax-deferred annuity, is a contract between a person and an insurance company for a guaranteed interest-bearing policy with guaranteed income options. The insurance company credits interest, and the annuity owner does not pay taxes on the earnings until they make a withdrawal or begin receiving an annuity income. In addition to the underlying guarantees, their annuity contract earns a competitive return that is very safe.
Tax-Deferred Tax-deferred means postponing taxes on interest earnings until a future point in time. In the meantime, they earn interest on the money they’re not paying in taxes. They can accumulate more money over a shorter period of time, which ultimately will provide them with a greater income.
Tax-deferral Advantages Many people today are using tax-deferred annuities as the foundation of their overall financial plan instead of certificates of deposit or savings accounts. Although CD’s and Annuities are very similar there are significant differences between the two. No taxes are payable while their money is compounding in an annuity. Their money can grow faster in a deferred annuity than in a taxable investment with a similar interest rate. This is
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because earnings normally lost to taxes remain in their annuity and can generate additional earnings through the effects of compounding. They can also pay a lower tax on random withdrawals because they control the tax year in which the withdrawals are made, and only pay taxes on the interest withdrawn, Tax deferral gives them control over an important expense – their taxes. Any time they control an expense, they can minimize it. The longer they can postpone this particular expense, the greater their gain when compared to the gain they would make with a fully taxable account. Later, if they decide to take a monthly income, their taxes can be less because they will be spread out over a period of years. Like Certificates of Deposits, annuities have a penalty for early surrender, however most annuity contracts have a liberal “free withdrawal” provision. And, if they wait until retirement to receive their annuity income, they may be in a lower tax bracket, adding to the value of the income they receive.
The Tax-Deferred Advantage To illustrate the increased earnings capacity of tax-deferred interest, let’s compare it to fully-taxable earnings. $100,000 at 6.5% will earn $6,500 of interest in a year. A 28% tax bracket means that approximately $1,820 of those earnings will be lost in taxes, leaving only $4,680 to compound the next year. If these same earnings were tax-deferred, the full $6,500 would be available to earn even more interest. The longer you can postpone taxes, the greater the gain.
Tax-Deferred vs. Fully Taxable Certificate of Deposit Annuity Before-tax yield: 3.25% 3.25% After-tax yield: 1.85% 1.85% 1 year $51950 $53,250 5 years $60,540 $68,504 10 years $73,303 $93,857 15 years $88,757 $128,592 20 years $107,468 $176,182
Compare the Return $176,182 Accumulated in a Tax-Deferred Annuity
$107,468 Accumulated in a Taxable Account
The Difference: $69,214
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Safety A tax-deferred annuity is safe. A qualified legal reserve life insurance company is required to meet its contractual obligations to the owner. These reserves must, at all times, be equal to the withdrawal value of their annuity policy. In addition to reserves, state law also requires certain levels of capital and surplus to further increase policyholder protection. “Legal reserve” refers to the strict financial requirements that must be met by an insurance company to protect the money paid in by all policyholders. These reserves must be at all times, equal to the withdrawal value (principal plus interest less early withdrawal fees, if any) of every annuity policy. State insurance laws also require that a life insurance company must maintain certain minimum levels of capital and surplus, which provide additional policyholder protection.
No More 1099’s There is no withholding tax while an annuity is compounding; it is completely tax-deferred. If the owner requests a distribution (random withdrawals or annuity income), taxes will be withheld – unless they elect differently. Their election not to withhold can be made at the time they make their request. Because the interest is tax-deferred, it is not necessary to issue a Form 1099 while their money is compounding. Only when their interest is distributed (withdrawal or annuity income) will a Form 1099 be sent which will reflect the amount of interest that is actually received.
When Does Annuity Money Mature? An annuity policy does not “mature” like a bond or certificate of deposit. Both principal and interest will automatically continue to earn interest until withdrawn or the annuitant reaches age 100. They can let their money continue to grow, make withdrawals, or begin receiving an annuity income at any time.
What is the Penalty Tax and When Does it Apply? An IRS penalty tax, currently 10%, may be payable on any withdrawal of interest or “qualified” premium made prior to age 59½.
Avoids Probate? If a premature death should occur, the accumulated funds within their annuity may be transferred to their named beneficiaries, avoiding the expense, delay, frustration and publicity of the probate process. Like most assets, the annuity is part of their taxable estate. The heirs can chose to receive a lump sum payment, or a guaranteed monthly income.
Single Premium Annuities
What is a Single Premium Annuity As is obvious from its name, a single premium annuity is an annuity that is purchased with only one premium. Usually that single premium is relatively large, but does not have to be. Companies have minimums for this type of contract and can be a few thousand and up to several
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hundreds of thousands. The money placed in this annuity can be left to accumulate for the future when it can be withdrawn or have a settlement option applied at a time when the annuitant desires to have a steam of income begin to be paid out to them. This would be referred to as a Single Premium Deferred Annuity. A Single Premium Immediate Annuity is a contract between a person and an insurance company. By paying in a lump sum of money they are guaranteed to receive a series of payments over a period of time. The amount of the payment is determined by both the current interest rate at the time their contract is issued and by choices they make from a wide variety of payment options. Once their contract is issued, their payments are fully guaranteed for the period of time they have chosen.
Tax-Favored Income If they use after-tax funds to purchase a single premium immediate annuity, the income payments they receive are only partially taxable. The non-taxable portion of each payment is a level percentage that represents the return of principal over the life of the contract. Depending on their age and the payment option they chose, this percentage will vary. If they are using tax-qualified funds (IRA, TSA, 401k money for example) to purchase their Single Premium Immediate Annuity, the payments they receive are generally fully taxable as they receive them because they represent funds that have not been taxed before.
No Investment Risk Once their contract is issued, they can count on their payments not to change in amount or frequency. They will enjoy the financial security of a guaranteed income with no investment risk, Economic conditions or investment returns may change, but their payment is guaranteed to remain the same.
Income Options A Single Premium Immediate Annuity offers a variety of options so they may tailor their income schedule to suit their needs. They can chose to receive payments, monthly, quarterly, semiannually or annually. The payment options include: Period Certain Only "Period Certain" means a number of years they chose. Payments will continue for the duration of the number of years they chose, and then cease. If they should die before the end of the stated number of years, their beneficiary would continue to receive the payments for the remainder of those years. Life Only Payments will continue for the rest of their life. They cannot outlive their income. Upon their death, payments stop.
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Life and Period Certain Life and period certain means payments will continue for the rest of their life, but for no less than the stated number of years. If they should die before the end of the stated number of years, their beneficiary would continue to receive the payments for the remainder of those years.
Life Only with Guaranteed Minimum Option Payments will continue for the rest of their life. If they should die before they have been repaid their initial investment, the balance of their initial investment will be paid in like installments to their beneficiary.
Joint and Survivor Payments are guaranteed during the lifetime of two people. After the death of one, payments continue for the lifetime of the surviving person. They can choose to have either full payments, or a percentage they choose, to continue for the lifetime of the survivor. They can also specify a period certain, and if both individuals were to die within the period certain, payments would continue to the named beneficiary for the remainder of the period certain.
CD Type Annuities
Bonus Annuities
Interest Rates A Bonus Annuity is an annuity that usually offers a higher first-year interest rate that is guaranteed for one year. When an annuity policy is issued the company sets the first year interest rate. This rate is guaranteed for the first policy year and we refer to it as the current rate. The base rate is the interest rate which the company projects it will pay in the second year and thereafter. This base rate is also referred to as the “renewal rate” and it is not guaranteed. In fact some companies pay renewal rates which are less than the originally projected base rate. (Note: the difference between the current rate and the base rate is referred to as the bonus rate.) We use the Current Rate (for the first year) and the Base Rate (for each year thereafter) when we calculate the projected future annuity account values.
Characteristics As we saw earlier this category contains those annuity products where the number of years that the interest rate is guaranteed for is equal to the number of years the surrender charge exists. For example, annuity products that have a 5-year guaranteed interest rate and a 5-year surrender charge are examples of CD Type annuities. In the following example, a Single Premium Annuity offers a interest rate of 5.50% which is guaranteed for 5 years, the duration of the surrender charge is also 5 years.
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Interest Rate 5.50% - Guaranteed for 5 Years
Years 1 2 3 4 5 Percentage Surrender Charge 5.0% 4.0% 3.0% 2.0% 1.0%
Surrender Charges The surrender charges last for a specific period of years and one can calculate their projected “Account Value” for the number of years their surrender charges exist. For example; if the surrender charge of the policy lasts five years, they calculate their projected “Account Value” for only five years. The reason is that after the surrender charge expires the interest rate is dropped to the contractual guaranteed minimum and the policy values can be and are usually transferred to another annuity. To continue projecting the accumulated value beyond this point is meaningless.
Withdrawal Charges Like most annuities, Bonus and CD type annuities allow an annuity owner to withdraw interest from their annuity without penalty. Some annuities allow them to withdraw interest without paying a penalty at the end of the policy year or after 30 days, then as earned, thereafter. Almost all annuities allow annuity owners to withdraw up to 10% of their account value before a surrender charge or withdrawal charge is applied. They must know how the Withdrawal or Surrender Charges apply before they buy an annuity policy to save themselves unnecessary expenses. Most annuities offer a guaranteed interest rate for a period of time that is less than the number of years that the surrender charge applies. After the guaranteed interest period expires the insurance company then declares the new interest rate for that policy year. Most often when one buys an annuity one must be aware that the "renewal rate" will usually be lower than the initial guaranteed interest rate.
Equity Index Annuities Regarded as a new innovation, the Equity Indexed annuity in its simplest form is an annuity product that:
• provides the long-term potential growth of the stock market. This means that the interest rate set by the insurance company at the end of each policy year is based on the performance of the S&P 500 Index. The method by which the interest rate is calculated and the percentage of the gain of the S&P 500 Index that is credited to their annuity is referred to as the Participation Index Rate, and
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• an investment product that provides the downside guarantees of an annuity. This means that once one makes a premium payment they will never have less in their account than their premium payment and that once interest has been credited to their equity index annuity the value of their annuity will never decrease unless they make a withdrawal even if the stock market goes down.
An equity-indexed annuity is an annuity that earns interest that is linked to a stock or other equity index. One of the most commonly used indices is the Standard & Poor's 500 Composite Stock Price Index (the S&P 500).
How are They Different from Other Fixed Annuities? An equity-indexed annuity is different from other fixed annuities because of the way it credits interest to an annuity's value. Most fixed annuities only credit interest calculated at a rate set in the contract. Equity-indexed annuities credit interest using a formula based on changes in the index to which the annuity is linked. The formula decides how the additional interest, if any, is calculated and credited. How much additional interest they get and when they get it depends on the features of their particular annuity. An equity-indexed annuity, like other fixed annuities, also promises to pay a minimum interest rate. The rate that will be applied will not be less than this minimum guaranteed rate even if the index-linked interest rate is lower. The value of this annuity also will not drop below a guaranteed minimum. For example, many single premium annuity contracts guarantee the minimum value will never be less than 90 percent (100 percent in some contracts) of the premium paid, plus at least 3% in annual interest (less any partial withdrawals). The insurance company will adjust the value of the annuity at the end of each term to reflect any index increases.
What Are Some of the Contract Features? Two features that have the greatest effect on the amount of additional interest that may be credited to an equity-indexed annuity are the indexing method and the participation rate. It is important to understand these features and how they work together. The following describes some other equity-indexed annuity features that affect the index-linked formula.
Indexing Method One of the most confusing aspects of index annuities is the method the company uses to calculate the interest rate that the policy will earn. The indexing method is the approach used to measure the amount of change, if any, in the index. Some of the most common indexing methods are explained more fully below. All the methods that are used essentially measure the change in the S and P 500 Index over some period of time. The time periods that companies use are either the policy year, from the day the policy is issued to one year later or a specific term, a period of one or more years.
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Specific Term To understand more fully specific term an example is helpful. The S&P 500 was at 500 on the day one’s contract was issued and over the 5-year term of their contract the highest point the S&P 500 reached was 700. The gain of 200 S&P 500 points represents a 40% increase therefore the value of their contract would be increased by 40%. An annuity policy with an initial premium of $100,000 5 years later would be credited with a $40,000 of interest.
Policy Year Here’s an example to better illustrate the policy year calculation feature. The S&P 500 was at 500 on the day your contract was issued and during the policy year of your contract the highest point the S&P 500 reached was 550. The gain of 50 S&P 500 points represents a 10% increase therefore the value of your contract would be increased by 10%. An annuity policy with an initial premium of $100,000 one year later would be credited with a $10,000 of interest. *Both the specific term and policy year method examples above use the High-Water Mark in determining how much interest the policy earned. This methodology will also be further discussed later.
Percentage Change The change in the S&P 500 Index from the beginning of the term to the end of the term is expressed as a percentage. The term could be one policy year, 5 policy years or 7 policy years etc. If the S&P 500 was 500 at the beginning of the policy year and closed at 550 at the end of the policy year, there would have been a 10% increase in the S&P 500 Index. In years where the S&P 500 Index is negative the percentage credited to their policy is (0). In this case there would be no change in their policy value.
Ratchet Method or Annual Reset This method locks in the gain for that period which is usually one policy year. Once the interest is credited to their policy it becomes the value on which the next years gain is calculated.
Spread Method Companies that use this method calculate the increase in the S&P 500 for that policy year or term then subtract a percentage from that change. For example, if the gain in the S&P 500 for a policy year was 12% and the company used a spread of 2%, then, 10% would be credited to their policy for that year.
High Water Mark The index-linked interest, if any, is decided by looking at the index value at various points during the term, usually the annual anniversaries of the date they bought the annuity. The highest level of the index during the period is noted. The interest then is based on the difference between this highest index value and the index value at the start of the term. Interest based on the “high water” mark is added to their annuity at the end of the term.
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Low Water Mark The index-linked interest, if any, is decided by looking at the index value at various points during the term, usually the annual anniversaries of the date they bought the annuity. The low water mark is noted. The interest is based on the difference between the index value at the end of the term and the lowest index value. Interest based on this calculation is added to their annuity at the end of the term.
Interest Rate Crediting This is the way in which companies’ credit interest varies. This can make a big difference in amount of money one’s policy will earn.
Adding Interest Some companies will only add interest to their annuity. For example, if they paid a $50,000 premium and during the first policy year they earned $5,000. The interest for the second policy year is calculated on $50,000 NOT $55,000. There is no compounding of interest that will lower their ultimate rate of return.
Margin-Spread-Administrative Fee When a company calculates the interest for one’s policy, they will subtract a specific predetermined percentage from the interest rate calculated and credit their account with the balance. In some annuities, the index-linked interest rate is computed by subtracting a specific percentage from any calculated change in the index. This percentage, sometimes referred to as the "margin," "spread," or "administrative fee," might be instead of, or in addition to, a participation rate. For example, if the calculated change in the index is 10%, their annuity might specify that 2.25% will be subtracted from the rate to determine the interest rate credited. In this example, the rate would be 7.75% (10% - 2.25% = 7.75%). In this example, the company subtracts the percentage only if the change in the index produces a positive interest rate.
Vesting Some annuities credit none of the index-linked interest or only part of it if one takes out all of their money before the end of the term. The percentage that is vested, or credited, generally increases as the term comes closer to its end and is always 100% at the end of the term.
Participation Rate The participation rate determines how much of the increase in the index will be used to calculate index-linked interest to be credited to their policy for that year. For example, if the calculated change in the index is 9% and the participation rate is 70%, the index-linked interest rate for their annuity will be 6.3% (9% x 70% = 6.3%). A company may set a different participation rate for newly issued annuities as often as each day. Therefore, the initial participation rate in their annuity will depend on when it is issued by the company.
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The company usually guarantees the participation rate for a specific period (from one year to the entire term). When that period is over, the company sets a new participation rate for the next period. Some annuities guarantee that the participation rate will never be set lower than a specified minimum or higher than a specified maximum. The participation rate may vary greatly from one annuity to another and from time to time within a particular annuity. Therefore, it is important for one to know how their annuity's participation rate works with the indexing method. A high participation rate may be offset by other features, such as “averaging” or a “point-to-point” indexing method. On the other hand, an insurance company may offset a lower participation rate by also offering a feature such as an “annual reset” indexing method.
Cap Rate or Cap on Interest Earned Some annuities may put an upper limit, or cap, on the index-linked interest rate. This is the maximum rate of interest the annuity will earn. In the example given above, if the contract has a 6% cap rate, 6%, and not 6.3%, would be credited. Not all annuities have a cap rate. While a cap limits the amount of interest one might earn each year, annuities with this feature may have other product features they want, such as annual interest crediting or the ability to take partial withdrawals. Also, annuities that have a cap may have a higher participation rate.
Floor on Equity Index-Linked Interest The floor is the minimum index-linked interest rate you will earn. The most common floor is 0%. A 0% floor assures that even if the index decreases in value, the index-linked interest that you earn will be zero and not negative.
Averaging Instead of using the percentage change over the policy year, some companies use an averaging method. They calculate the change by averaging the daily closing S&P 500 values or the monthly S&P 500 values. The averaging method also tends to lower the overall rate of return of the S&P 500 Index, similar to that of a "cap". In rising markets, the averaging method limits the increase that would be credited to their annuity policy. In some annuities, the average of an index's value is used rather than the actual value of the index on a specified date. The index averaging may occur at the beginning, the end, or throughout the entire term of the annuity. Averaging at the beginning of a term protects one from buying their annuity at a high point, which would reduce the amount of interest they might earn. Averaging at the end of the term protects them against severe declines in the index and losing index-linked interest as a result. On the other hand, averaging may reduce the amount of index-linked interest they earn when the index rises either near the start or at the end of the term.
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How Common Indexing Methods Differ
Annual Reset As you will recall index-linked interest, if any, is determined each year by comparing the index value at the end of the contract year with the index value at the start of the contract year. Interest is added to one’s annuity each year during the term.
Advantage Since the interest earned is "locked in" annually and the index value is "reset" at the end of each year, future decreases in the index will not affect the interest they have already earned. Therefore, their annuity using the annual reset method may credit more interest than annuities using other methods when the index fluctuates up and down often during the term. This design is more likely than others to give them access to index-linked interest before the term ends.
Disadvantage Their annuity's participation rate may change each year and generally will be lower than that of other indexing methods. Also, an annual reset design may use a cap or averaging to limit the total amount of interest they might earn each year.
High-Water Mark As discussed previously, companies that use this method take the value of the S&P 500 Index on the day their policy is issued and subtract that value from the highest value the S&P 500 reaches during the term of their contract. The terms most commonly used are 5 and 7-year durations. The index-linked interest, if any, is decided by looking at the index value at various points during the term, usually the annual anniversaries of the date they bought the annuity. The interest is based on the difference between the highest index value and the index value at the start of the term. The amount of money they initially deposited in their policy is multiplied buy their percentage change to arrive at their contract value. Interest is added to their annuity at the end of the term.
Advantage Since interest is calculated using the highest value of the index on a contract anniversary during the term, this design may credit higher interest than some other designs if the index reaches a high point early or in the middle of the term, then drops off at the end of the term.
Disadvantage Interest is not credited until the end of the term. In some annuities, if they surrender their annuity before the end of the term, they may not get index-linked interest for that term. In other annuities, they may receive index-linked interest, based on the highest anniversary value to date and the annuity's vesting schedule. Also, contracts with this design may have a lower participation rate than annuities using other designs or may use a cap to limit the total amount of interest they might earn.
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Point-to-Point The index-linked interest, if any, is based on the difference between the index value at the end of the term and the index value at the start of the term. Interest is added to their annuity at the end of the term. The term period may be one policy year or 3, 5, 7 policy years.
Advantage Since interest cannot be calculated before the end of the term, use of this design may permit a higher participation rate than annuities using other designs.
Disadvantage Since interest is not credited until the end of the term, typically six or seven years, they may not be able to get the index-linked interest until the end of the term.
How Do I Know Which Equity-Indexed Annuity is Best for Me? As with any other insurance product, one must carefully consider their own personal situation and how they feel about the choices available. No single annuity design may have all the features they want. It is important to understand the features and trade-offs available so they can choose the annuity that is right for them. Keep in mind that it may be misleading to compare one annuity to another unless one compares all the other features of each annuity. They must decide for themselves what combination of features makes the most sense for them. Also, remember that it is not possible to predict the future market behavior of an index.
What is the S&P 500 Composite Stock Price Index?
Standard & Poor’s 500 This is an index which was devised a number of years ago by the Standard & Poor's Company. Today the S&P 500 Index is widely regarded as the benchmark index by which U.S. stock market performance is measured. It includes a representative sample of common stocks traded on the New York Stock Exchange, American Stock Exchange and NASDAQ National Marketing System. It is one of the U.S. Commerce Department leading indicators. In addition, it represents over 70% of the total domestic U.S. equity market capitalization.
History The origins of the S&P 500 Index go back to 1923 when Standard & Poor's introduced a series of indices which included 233 companies and covered 26 industries. The Index as it is now know was introduced in 1957. Today, the S&P 500 encompasses 500 companies representing 90 specific industry groups.
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Distribution of the S&P 500 Index Automatic Data Processing (ADP) disseminates S&P 500 Index values every 15 seconds during the trading day. ADP also transmits Index values to the Chicago Mercantile Exchange, where S&P 500 futures trade, and the Chicago Board Options Exchange, home of the S&P 500 Options. The exchanges in turn distribute the index values to numerous quotation vendors. This insures the widest possible means of distribution. The S&P 500 Index is reported daily in The Wall Street Journal, The New York Times, U.S.A. Today, and virtually every major regional and local newspaper. The "500" is also reported on most television and radio business programs.
S&P Index Committee The S&P Index Committee is responsible for establishing index policy. The management of the S&P 500 Index is totally objective and independent from S&P’s other business operations and interests. Maintaining stability of the composition of the S&P 500 Index is a primary consideration. Companies within the Index are generally removed because of mergers, acquisitions and bankruptcy filing. Companies are not removed from the Index because of anticipated good performance.
Comparison to the Dow Jones Industrial Average • The Dow Jones Industrial Average is the oldest index and probably the most well-
known gauge of stock market performance.
• The Dow is composed of 30 large capitalization, blue-chip stocks and measures the performance of a relatively small sector of the market.
The S&P 500 Index • The primary objective of the Standard & Poor's 500 Composite Stock Price Index,
known as the S&P 500, is to be the performance benchmark for the U.S. stock market performance.
• The S&P Index is a market value-weighted index (shares outstanding times stock
price) in which each company's influence in Index performance is directly proportional to its market value.
• The S&P 500 does not contain the 500 largest stocks. Although many of the
stocks in the Index are among the largest, there are also some relatively small companies. However, they are generally leaders within their industry group.
• S&P identifies important industry groups within the U.S. economy and then allocates a representative sample of stocks within each group to the S&P 500. There are four major industry sectors within the Index: Industrials, Utilities, Financial and Transportation.
• Since 1968 the Index has been a component of the U.S. Commerce Department's
list of leading indicators which track key sectors of the U.S. economy.
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Standard & Poor's 500 Index History
Year S & P 500 Index Consumer Price Index
2016 -13.04% 2.80% 2015 -1.16% 3.40% 2014 13.69% 2.20% 2013 32.39% 1.60% 2012 16.00% 2.30%
2011 2.11% 2.80% 2010 15.06% 3.40% 2009 19.55% 2.20% 2008 26.46% 1.60% 2007 5.49% 2.30%
2006 15.79% 2.80% 2005 4.91% 3.40% 2004 10.88% 2.20% 2003 26.68% 1.60% 2002 -22.10% 2.30%
2001 -13.04% 2.80% 2000 -10.16% 3.40% 1999 19.55% 2.20% 1998 26.64% 1.60% 1997 31.01% 2.30%
Bond Index Annuities Like Equity Index annuities, Bond Index annuities credit interest based on the performance of a third-party index. In this case, it is a prescribed group of bonds that have been identified to reflect the performance of selected risk\reward groups of bonds combined to form a pool on which a bond index can be calculated over a period of time. This bond index is then applied to determine the actual interest that will be credited to the accumulated funds in the annuity. There are an increasing number companies that are combining different types of annuities within a single product. It now possible to buy one annuity product that offers people the choice of placing all or part of their funds in a CD Type, Equity Index, Fixed or Bond Strategy Account. The following is a list of such products and the accounts that are available within those products. The last 3 bond references are key to this discussion of bond index annuities. They give examples of various types of bond indexed groupings that underlie the bond indexed annuity and upon which their index will determine the interest to be credited to the annuity.
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Fixed Account Traditional fixed annuities such as those listed in Fixed Annuity Category.
CD Type Account Annuities where the guaranteed period is equal to the surrender charge period. Those products are listed in the CD Type Annuities Category.
Equity Index Accounts Products that offer interest crediting methods based on the performance of one of the major indices such as the S&P 500 Index. These types of products are listed in the Equity Index category.
Convertible Bond Account A portfolio of bonds designed for those who want to take advantage of the stability of the bond market and have the potential for stock-like returns. This portfolio is designed to produce rates of return similar to that of the Merrill Lynch Convertible Bond Index.
Investment Grade Account A portfolio of bonds designed for those who want returns based on the long-term stability of the bond market. This portfolio is designed to produce rates of return similar to the Lehman Brothers Government/Corporate Bond Index.
High Yield Bond Account A portfolio of bonds designed for those who want rates of returns based on bonds rated BBB or less by Standard & Poor’s. A high yield bond offers a higher yield that corresponds to a higher level of risk than investment grade bonds. The Lehman Brothers High Yield Bond Index tracks the performance of high yield bonds.
Bond Indexed annuities give us another choice of performance-backed annuities that have varied methods of growth potential to best adapt to a person’s needs for diversification and accumulation for the future, given varying market and interest rate environments.
Market Value Adjusted Annuities Market Value Adjustments on annuities and life policies have been around for over a decade, but MVAs on annuities have become much more popular, particularly since early 1994 when the Fed began decreasing rates at a rapid pace. A Market Value Adjustment (MVA) can be attached to a deferred annuity that features fixed interest rate guarantees combined with an interest rate adjustment factor that can cause the actual crediting rates to increase or decrease in response to market conditions.
How the MVA Works
• The owner places money in an account that earns a fixed rate of interest (the annuity values are supported by the full faith and credit of the insurance company).
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• The insurer holds the owner’s money in this account for the length of the designated guarantee period. At the end of the guarantee period there is usually a “window” when no withdrawal charges or market value adjustment will apply.
• At the end of the guarantee period, the company declares a new current interest rate, or
renewal rate, which may be higher or lower than the previous rate, but not below the minimum interest rate guaranteed by the policy (typically 3% or 4%).
How the MVA is Different If one wants to surrender their annuity prior to the end of the guarantee period, an “adjustment” will be made. The actual contract value they receive has the potential to be positively or negatively affected by current market conditions. Because the issuing company has invested their premium to ensure it can pay them the rate guaranteed in their contract, it could lose money if it had to sell those investments at a discount to refund their premium plus their earnings. The reverse can also be true.
Risk Factor The MVA serves to protect the insurance company against investment losses incurred by early withdrawals. By having a more predictable pattern of withdrawals, MVA annuities have a greater potential to credit higher interest rates than the traditional fixed annuity. As with equities, bonds and variable annuity products, MVA annuities can provide opportunities for market gain. But they also offer the security found in traditional fixed deferred annuities, typically with no extra sales or administrative fees. In a declining interest rate environment, the annuitant has the security of a guaranteed rate common to fixed annuities. In addition, due to the mechanics of the MVA feature, much like a bond, the market- adjusted value of the product actually increases as interest rates decline. In this environment, the credited rate should be better than new money alternatives, which showed a decline since the annuity was issued. On the other hand, in an increasing rate environment, as with a bond, the market-adjusted value of the contract may decrease. Here is where insurers start to differ with product architecture: One sells a MVA where, unlike a bond, the annuitant is guaranteed the surrender value will never be less than premium paid accumulated at minimum guaranteed interest, less applicable surrender charges.
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Chapter 3 Objectives Upon completion of this section, you will:
§ Gain increased awareness of the unique investment product in variable annuities. § Be better informed about the inner workings of variable annuities. § Be able to better explain withdrawals, taxes, risks, and penalties in variable annuities.
Chapter 3 Variable Annuities
Unique Investment Product
A Variable Annuity is a unique investment product that provides tax deferral of interest and capital gains and the option of a guaranteed monthly income, which one cannot outlive. Variable Annuities provide the advantages of traditional fixed annuities with the potential returns that are available by investing one’s money in the stock market. The investment options that people may choose from in a variable annuity are referred to as "sub accounts". These “sub accounts” are structured as either "mutual funds" or as segregated "investment portfolios" that are managed by professional investment managers.
Family of Funds Many variable annuities offer more than one family of funds to choose from and within each family of funds they may choose from a variety of funds with different investment objectives. This allows them to diversify their investment portfolio to minimize risk and maximize their potential investment return. Unlike fixed annuities with guaranteed protection against loss of principal, their principal is at risk and subject to loss in value.
Loading and Management Fees § Administrative Fees: The issuing insurance company usually charges an
Administrative Fee and a Mortality Risk Fee totaling 1.0% to 2.0% of assets - the typical fee usually is about 1.25% of assets.
§ Contract Fee: Many companies charge a flat dollar amount varying from $20.00 to $40.00 per year.
§ Sub-Account Fees: The charges for the operation and management of the sub-account range from .15% to 1.50% of assets.
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§ Stepped-Up Death Benefit: In event of death during the accumulation period of a variable annuity many companies have this provision. The death benefit paid to the beneficiary is the greater of:
o The Contract Value at the time of death o The Total Premiums paid into the contract o The Contract Value on the prior (ie, 5th, 6th, 7th) Anniversary Date of the
contract § Withdrawal Provision: Most, if not all, contracts that have Surrender Fees have a
Withdrawal Provision. This provision typically allows one to withdraw up to 10% of the account value after the first year without incurring a surrender fee.
§ Surrender Fees: Deposits to the contract are not subject to a "load" or "front end fee" however withdrawals may be subject to a contingent deferred sales charge (CDSC) such as:
Year 1 2 3 4 5 6 7 Percent 7 6 5 4 3 2 1
Charges are either based on "date of deposit" or "date of contract". A contract in this example that uses a "date of contract" method would have no charges imposed after seven years - even for new deposits.
Advantages of Variable Annuities The major advantage of a variable annuity is the tax advantage of deferred taxes on dividends, interest and capital gains that are credited to the sub-accounts in which they are earned - until withdrawn. One must be aware that withdrawals prior to age 59½ are subject to a 10% penalty imposed by the IRS and the amount withdrawn is subject to ordinary income. Secondly, with a variable annuity one’s money is invested in mutual funds, which allow for the opportunity of growth, which is available in the stock market.
Tax Treatment of Variable Annuities Variable Annuities are generally a tax favored investment product when purchased by an individual on a non-qualified basis. The growth is tax deferred and therefore not subject to current income taxation. Variable Annuities purchased as part of a qualified retirement plan such as an IRA, 401(k), TSA - 403(b) or Deferred Compensation Plan - 457 are taxed under the special tax provisions governing that qualified retirement plan.
Required Distributions… To be taxed as an annuity under Section 72(s) of the IRS Code all non-qualified annuity contracts must contain the following two provisions;
• If the owner of the annuity begins withdrawing money from the annuity and dies, the policy must allow withdrawals to continue at the same rate or faster.
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• If the owner of the annuity dies before withdrawals have begun and the beneficiary of the annuity is the spouse of the owner, the annuity may be continued with the spouse as the new owner. If the owner dies before withdrawals have begun and the beneficiary is not the spouse of the owner then; a) the entire value of the contract must be distributed within five years of the owner’s death or b) beginning within one year of the date of the death of the owner the beneficiary may elect to begin distribution of the proceeds over his life expectancy.
Taxation of Variable Annuities If the owner of the annuity is a person, not a business entity, then increases in the value of the annuity contract are not taxed until a distribution occurs by withdrawing all or part of the annuity value or selecting an annuity payout option. In addition, if one assigns or pledges any portion of the value of their annuity contract it will generally be treated as a distribution. The taxable portion of a distribution is taxed as ordinary income. If the contract is owned by other than a natural person such as a business entity then the increase in value over the investment in the annuity must be included as income during the year.
Withdrawals Withdrawals, including systematic withdrawals, from a non-qualified variable annuity, are first treated as taxable income if, at the time the withdrawal is made, the value of the annuity is greater than the "investment in the annuity." In the case of a full withdrawal from an annuity contract, taxes are paid only on the gain above the "investment in the annuity."
Penalty Tax on Premature Distributions Distributions from a non-qualified annuity prior to age 59½ are subject to a penalty equal to 10% of the amount treated as taxable income. However, there are no penalties on distributions:
§ Made after the taxpayer reaches ages 59½. § Made on or after the death of the owner of the annuity. If the owner is not an
individual then the death of the primary annuitant. § If the taxpayer became disabled. § A part of a series of substantially equal periodic payments (not less than annually) for
the life (or life expectancy) of the taxpayer or the joint lives (or joint life expectancies) of the taxpayer and his or her designated beneficiary;
§ Made under an annuity contract that is purchased with a single premium when the annuity starting date is no later than a year from purchase of the annuity and
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substantially equal periodic payments are made, not less frequently than annually, during the annuity period;
§ Made under certain annuities issued in connection with structured settlement agreements.
Taxation of Death Benefit Proceeds Amounts withdrawn because of the death of the owner of the annuity or annuitant are taxed as a full withdrawal. The gain over the "investment in the annuity" is taxed as ordinary income. Proceeds that are withdrawn under a payout option are taxed the same way as annuity payouts.
Accumulation Period During the accumulation period of a variable annuity all premium payments can be invested in either a fixed account or “sub accounts” or both. The fixed account earns a guaranteed rate of interest and your principal is also guaranteed and not subject to market fluctuations. Premiums invested in the “sub accounts” (mutual funds) have the opportunity to participate in the growth of the stock market however these funds are subject to market risk. Historically it can be demonstrated that funds invested in a diversified portfolio of prudently invested stocks can outperform other investment options given enough time.
Distribution Period
During retirement, funds can be withdrawn from the contract and the owner has several options to choose from. Withdrawals may be made at any time from the contract, prior to retirement as well, usually with a minimum dollar amount and at the option of the owner. Systematic Withdrawal Plan enables the owner to pre-authorize periodic withdrawals. The owner of the contract instructs the company to withdraw a percentage or a level dollar amount from the contract on a monthly, quarterly, semiannual, or annual basis. Checks are sent directly to the owner or can be deposited directly into the owner’s checking account. Annuitization is one of the least utilized and often misunderstood options of a variable annuity contract. The owner of the contract may elect to allocate all or part of the value of the contract to either the fixed account and/or the separate account. Allocations to the fixed account will provide annuity payments on a fixed basis; amounts allocated to the separate account will provide annuity payments on a variable basis reflecting the investment performance of the underlying subaccount.
Fixed Account The owner of the contract may transfer all or part of the value of the contract to the fixed account, sometimes called the guaranteed account, and elect to annuitize those funds. In essence
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the owner of the contract for a fixed dollar amount, purchases a monthly income, which will be paid to him/her until death. For instance, a 68-year-old male could receive a monthly income which would be payable to himself as long as he is alive, or to his beneficiary should he die within the first 10 years. This option is known as "Life Annuity with Payments for a Guaranteed Period"; in this case the guaranteed period is ten years. Contracts when issued include a "payout table" stating the minimum payout guaranteed by the company based on age and sex (according to state law). When the contract is annuitized the payout will be based on the higher value of the guaranteed amount stated in the table or the current values used at that time. In this example, according to the payout table, for every $1,000 that is annuitized under the "Life Annuity with Payments Guaranteed for 10 Years Option" the monthly payout would be $5.68. This is what was guaranteed at the time the contract was issue however the current payout rate which the company is using is $7.93. All payout rates are expressed as dollars per period (monthly, quarterly, semiannually, annually) per $1,000 dollars. Therefore, if this individual elected to annuitize $30,000 under this option his monthly payout would be $237.90 per month. This dollar amount is guaranteed to be paid to him as long as he is alive. Should death occur in the first ten years his beneficiary would receive the difference between 10 years of monthly income and the amount he actually received.
Separate Account The owner of the contract may transfer all or part of the value of the contract to one or more of the “sub accounts” that are available in the separate account and elect to annuitize those funds. For example, if there were 12 subaccounts available in the separate account the owner could transfer $25,000 in to the Growth & Income subaccount and $30,000 into the International subaccount and annuitize each account. The difference between annuitizing funds in the fixed account and funds in the separate account is that funds in the fixed account produce a guaranteed income that will not change from period to period. Funds that are annuitized in the separate account produce an income that will change from period to period based on the performance of the “sub account” that the funds are placed in.
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Chapter 4 Objectives Upon completion of this section, you will:
§ Learn about and gain increased awareness of specialized annuities. § Be able to talk confidently to eligible clients about how TSAs work and benefit them. § Learn about impaired risk annuities.
Chapter 4 Specialized Annuities
Tax Sheltered Annuities (TSAs) If a person works for a public school or certain tax-exempt organizations such as religious, charitable, educational, scientific and literary organizations described in IRC Sec. 501(c)(3), they may be eligible to participate in a TSA retirement plan offered by their employer. TSA plans are commonly referred to as 403(b) plans. TSA participants can invest funds in annuity contracts, custodial accounts holding mutual fund shares, or retirement income accounts (for certain plans maintained by churches). Special rules apply to figure the cost of the life insurance premiums paid to cover any incidental life insurance protection.
Three Benefits There are three benefits to contributing to a TSA.
First, one does not pay tax on the contributions they make in the year that they are made. There are either excludable or deductible from one’s income. They do not pay taxes on these amounts contributed until they retire when is the time most people plan to begin distributions to supplement their income after retirement. Second, earnings and gains within their TSA are not taxed until they are withdrawn. Thirdly, in the years after 2001 they may be eligible to take credit for elective deferrals that they contribute to their TSA.
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Can their Employer Make Contributions for them? A person cannot set up his or her own TSA. Only their employer can. But typically, the employee agrees to have his or her salary reduced by the amount to be contributed. If the employer contributes its own funds, the arrangement is subject to many of the same rules that govern regular qualified plans.
How can contributions be made? Generally, only one’s employer can make contributions to their 403(b) account. However, some plans will allow them to make after-tax contributions (defined later). The following types of contributions can be made to 403(b) accounts.
Elective Deferrals These are contributions made under a salary reduction agreement. This agreement allows their employer to withhold money from their paycheck to be contributed directly into a 403(b) account for their benefit. They do not pay tax on these contributions until they withdraw them from the account.
Non-elective contributions These are employer contributions that are not made under a salary reduction agreement. One cannot pay tax on these contributions until they withdraw them from the account. Non-elective contributions include matching contributions, discretionary contributions, and mandatory contributions from their employer.
After-tax contributions These are contributions they make with funds that they must include in income on their tax return. A salary payment on which income tax has been withheld is a source of these contributions. If their plan allows them to make after-tax contributions, these are not excluded from income and they cannot deduct them on their tax return.
Combination A Combination of any of the three contribution types listed above.
How Much Can Be Contributed? If past service is ignored, generally up to 20% of compensation can be contributed (not to exceed $18,000 in 2017). If it is desirable to use past service as a contribution base, then it is often possible to exceed the 20% limit, but the actual contribution may not exceed the lesser of 25% of compensation or $54,000 (2017). However, the rules are very complex and depend on the actual facts. Other limits may also be imposed.
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When can a TSA be Set Up? A TSA can be set up at any time during the year; however, an employee’s salary reduction agreement must be entered into before the reduced amounts are available to the employee. An employee can later modify their deferral amount, but only with respect to future income.
What can TSA Funds be Invested In? There are three choices:
• Annuities (fixed or variable and individual or group) • Custodial accounts invested in mutual funds • Combination of whole life insurance and annuities
Who Is the Custodian of the Assets? Annuities and insurance are with an insurance company. Mutual funds are placed with a corporate trustee.
When Is a Distribution Required? Generally, a person withdraws their funds at their retirement. In order for them to avoid penalties, their withdrawals must begin in the calendar year during which they became 70½ or, if later, the calendar year during which the employee actually retires. At a minimum, the funds must be taken out over the life expectancy of the person and, if desired, his or her spouse.
What Is the Penalty for Early Withdrawals? There is a 10% penalty for withdrawals prior to age 59½, and all withdrawals are taxed currently as ordinary income unless the distribution is rolled over; transferred to another TSA; or the annuitant is totally disabled, separates from service (after age 55), or dies. Also, a person’s salary reduction amounts (but not the earnings) are available for financial hardship; e.g., an immediate and heavy financial need which cannot be met with other assets.
Can TSA Funds Be Borrowed? Yes. Participants can borrow funds from their TSA and then later restore them without incurring a tax, if established conditions are met regarding maximum loan amount, amortization requirements, time period for repayments, etc.
What Happens at the Death of a TSA Participant? If a participant with a TSA dies, the proceeds become a part of their taxable estate for Federal Estate Tax purposes, and they are considered as ordinary income to the beneficiary, except for any “pure” insurance proceeds that might be a part of the death benefits.
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How Does a Participant Change from One TSA to Another? A participant is allowed to transfer their funds from one 403(b) investment to another and it will not be considered a taxable distribution if the funds remain subject to the distribution restrictions on the prior investment. If a TSA is rolled directly into an IRA, it will defer taxation. If it is paid to the participant first, it will be subject to the mandatory 20% income tax withholding rule.
Can Deferred Amounts Be Counted as Current Compensation? Yes, deferred amounts can be counted as current compensation in computing benefits under a separate qualified pension plan, if the qualified plan so provides.
Impaired Risk Annuities
Immediate Annuities - Is Bad Health Good? Yes! When it comes to impaired risk immediate annuities. With an impaired life annuity, the annuitant's insurance age is RATED to be OLDER than his or her chronological age. This is advantageous since the monthly income based on a rated or older age is higher than the income calculated using the person's actual age, given the same deposit amount. The insurance company pays a higher monthly income for an impaired life because the annuitant is not expected to live as long as the average person of the same chronological age. The shorter the life expectancy, the higher the monthly income. With this type of annuity, the annuitant provides the insurance company with an attending physician’s statement (APS) and/or hospital records for review. A short time later the insurance company will offer a “standard” rate if the medical history does not influence their mortality tables, or they will offer a “rated age” if they feel the medical history of the annuitant warrants a shorter life expectancy. The rated age would be older than the annuitant’s actual age. Since the payout or income from the annuitant’s deposit is partly determined by age, the payout or income would be higher than it would be if the actual age were used for the calculation. For this reason, it is beneficial to provide as much medical information as possible to the insurance company in order for them to give a fair assessment.
Payments can actually be geared higher to begin with if one is not healthy. Impaired risk underwriting is a process by which physicians or underwriters evaluate the life expectancy of an individual based on his or her health. Individual medical conditions are considered and a variety of risk factors including high blood pressure, heart disease and diabetes can result in a reduced life expectancy. The longer the life continent element of the annuity, the greater the potential savings to the consumer." (Or in layman's terms, if you are not going to live that long, your payout for dollar invested will be higher than normal since you are going to die sooner than the average individual.) "So impaired risk annuities can benefit consumers by either reducing the premium for a specific stream of payments or by providing an increased benefit for the same premium."
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Assume a woman age 70 wants a guaranteed $1,000 a month for retirement. She is not in good health. Based on her medical condition, she has a life expectancy of a 74-year-old. A regular annuity would cost $159,204. But due to her condition, it would cost only $142,560. Or, assume a man age 65 has a single premium deferred annuity with a cash value of $125,000. If he buys a single premium immediate annuity with a 10-year certain and life option, he would get $1,048 based on his life expectancy of a man at age 70 due to his medical conditions. As a normal person age of 65, he would have received $960. Not all companies that offer immediate annuities will offer impaired immediate annuities.
Generally, the funds from those annuitants who die young go towards paying for those who live longer than expected. If one of these companies were to enter into the impaired annuity market it would be jeopardizing its competitiveness in its core area. By offering enhanced rate annuities alongside standard rate annuities, the company's cross-subsidy system would weaken. This is because impaired annuitants, who receive significantly higher annuity payments than their standard annuity counterparts, would obviously opt for these products, thereby removing the existing cross-subsidy that provides for healthy annuitants. This would cause a natural downward adjustment to the annuity rates offered to the company's non-impaired risk group - and, as a result, the company would lose some of its competitive edge.
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Chapter 5 Objectives Upon completion of this section, you will:
§ Gain increased understanding of taxation and distribution issues in annuities. § Discover how to calculate the MRD for a client. § Be better informed about what 1035 exchanges are and how they work.
Chapter 5 Taxation, Distribution & Exchanges
Taxation & Distribution What makes annuities different is the tax treatment given them by the IRS? Think of an annuity as an umbrella. When money is placed under the umbrella or annuity contract, it is treated differently as far as taxes go.
§ The money that is put in an annuity is referred to as a premium; it's one’s original contribution or principal contribution. Since they already have paid taxes on it, it never again will be subject to taxation. This assumes that they haven't purchased an annuity as part of a qualified retirement program such as an IRA, 401(k), TSA or 457 Plan.
§ The money that they put into an annuity will earn interest or receive dividend
income or capital gain distributions. These "earnings", unlike money in a savings account, mutual fund, certificate of deposit are not taxed in the year in which they are earned. Thus the "earnings" will continue to grow and compound tax free until withdrawn.
§ The IRS eventually collects taxes on the "earnings" of their annuity.
§ When they withdraw money from their annuity, the earnings,
according to the IRS, are withdrawn first. The "earnings" are subject to "ordinary income taxes" in they year in which they are withdrawn. Keep in mind that capital gain distributions in a mutual fund are taxed at capital gains rates.
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§ The IRS also has what it calls "Premature Distributions" if they withdraw their earnings and they’re under the age of 59½. Not only are their earnings taxed at ordinary income tax rates, the IRS makes them pay a penalty of an additional 10% on the earnings that are taxed.
§ However, there are no penalties on distributions:
§ Made after they are 59½. § Made on or after the death of the owner of the annuity. § If the taxpayer becomes disabled. § A part of a series of substantially equal periodic payments (not less than annually)
for the life (or life expectancy) of the taxpayer or joints lives (or joint expectancies) of the taxpayer and his or her designated beneficiary.
§ Made under a single premium immediate annuity with a starting date no later than one year from the annuity purchase date.
§ Made under certain annuities issued in connection with a structured settlement agreement.
Avoid Probate If a premature death should occur, the accumulated funds within their annuity may be transferred to their named beneficiaries, avoiding the expense, delay, frustration and publicity of the probate process. Like most assets, the annuity is part of their taxable estate. Their heirs can generally choose to receive a lump sum payment, or a guaranteed monthly income.
Minimum Required Distributions Once they have retired they can postpone withdrawing their money from their retirement plan until they have reached the age of 70½. In the calendar year in which they turn age 70½ they must make their first withdrawal by the time they reach age 70½. In future years they are required to make a withdrawal by the end of the calendar year.
Retirement Plans Covered If they have an IRA, 401(k), SEP-IRA, TSA or SIMPLE Plan they are required to begin minimum distributions by age 70½. Roth IRA's are NOT covered by the MRD rule.
Multiple Retirement Plans If they have more than one retirement plan from which minimum required distributions must be made, they must calculate the amount required for each plan. The actual minimum distribution may be taken from one plan to satisfy the MRD. The value used to calculate the MRD is the total value of each plan as of December 31st of the preceding year.
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IRA Penalty Failure to make the required distribution by the end of the calendar year results in a penalty equal to 50% of the amount of the distribution. In addition, ordinary income taxes are due on the entire amount, as well. Calculating the MRD (Minimum Required Distribution) Calculating the MRD is easy. Take their account balance as of December 31 of the preceding year and divide by their life expectancy. Account Balance
§ Contributions - Includes all contribution made in the immediate preceding year for which the calculation is being made.
§ Distributions - When calculating the distribution for the second year only, it is reduced by any distribution made in that year to satisfy the minimum distribution requirement for the first year. The first-year distribution year is the year in which they reach age 70½.
Life Expectancy
§ Single Life Expectancy - The owner’s life expectancy as set forth by IRS § Joint Life Expectancy - The owner and designated beneficiary set forth by IRS
Death of Owner - If the owner dies before distributions have begun, the remaining life expectancy of the beneficiary.
Distributions Prior to Age 59½ If they make a withdrawal prior to age 59½ from their traditional IRA they must pay an additional tax of 10%. This tax is 10% of the part of the distribution that they have to include in gross income. It is in addition to any regular income tax on the amount they have to include in gross income.
Exceptions to the Premature Distribution Penalty Tax There are exceptions to the premature distribution penalty tax for distributions made from traditional IRAs;
Unreimbursed Medical Expenses Even if they are under age 59½, they do not have to pay the 10% tax on amounts they withdraw that are not more than: The amount they paid for unremembered medical expenses during the year of the withdrawal, minus 7.5% (10% if under age 65) of their adjusted gross income for the year of the withdrawal.
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They can only take into account unremembered medical expenses that they would be able to include in figuring a deduction for medical expenses on Schedule A, Form 1040. They do not have to itemize their deductions to take advantage of this exception to the 10% additional tax.
Medical Insurance Even if they are under age 59½, they may not have to pay the 10% tax on amounts they withdraw from their traditional IRA during the year that are not more than the amount they paid during the year for medical insurance for themselves, their spouse, and their dependents. They will not have to pay the tax on these amounts if all four of the following conditions apply.
§ They lost their job § They received unemployment compensation paid under any federal or
state law for 12 consecutive weeks. § They make the withdrawals during either the year they received the
unemployment compensation or the following year. § They make the withdrawals no later than 60 days after they have been
re-employed.
Disability If they become disabled before they reach age 59½, any amounts they withdraw from their traditional IRA because of their disability are not subject to the 10% additional tax. They are considered disabled if they can furnish proof that they cannot do any substantial gainful activity because of their physical or mental condition. A physician must determine that their condition can be expected to result in death or to be of long continued and indefinite duration.
Death If they die before reaching 59½, the assets in their traditional IRA can be distributed to their beneficiary or to their estate without either having to pay the 10% additional tax. However, if they inherit a traditional IRA from their deceased spouse and elect to treat it as their own, any distribution they later receive before they reach age 59½ may be subject to the 10% additional tax.
Higher Education Expenses Even if they are under age 59½, if they paid expenses for higher education during the year, part (or all) of any withdrawal may not be subject to the 10% tax on early withdrawals. The part not subject to the tax is generally the amount that is not more than the qualified higher education expenses for the year for education furnished at an eligible educational institution. The education must be for them, their spouse, or the children or grandchildren of them or their spouse.
When determining the amount of the withdrawal that is not subject to the 10% tax, include qualified higher education expenses paid with any of the following funds.
§ An individual's earnings. § A loan. § A gift.
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§ An inheritance given to either the student or the individual making the withdrawal.
§ Personal savings (including savings from a qualified state tuition program).
Do not include expenses paid with any of the following funds. § Tax-free distributions from an education IRA. § Tax-free scholarships, such as a Pell grant. § Tax-free employer-provided educational assistance. § Any tax-free payment (other than a gift, bequest, or devise) due to
enrollment at an eligible educational institution. § Qualified higher education expenses. Qualified higher education
expenses are tuition, fees, books, supplies, and equipment required for the enrollment or attendance of a student at an eligible educational institution. In addition, if the individual is at least a half-time student, room and board expenses are qualified higher education expenses.
Eligible Educational Institution This is any college, university, vocational school, or other postsecondary educational institution eligible to participate in the student aid programs administered by the Department of Education. It includes virtually all accredited, public, nonprofit, and proprietary (privately owned profit-making) postsecondary institutions. The educational institution should be able to tell them if it is an eligible educational institution.
First Home To qualify for penalty-free withdrawal treatment as a first-time homebuyer distribution, a distribution must meet the following requirements.
§ It must be used to pay qualified acquisition costs before the close of the 120th day after the day they received it.
§ It must be used to pay qualified acquisition costs for the main home of a first-time homebuyer who is any of the following.
§ Themselves. § Their spouse. § Them or their spouse's child § Them or their spouse's grandchild § Them or their spouse's parent or other ancestor
When added to all their prior qualified first-time homebuyer distributions, if any, the total distributions cannot be more than $10,000. If both husband and wife are first-time homebuyers they each can withdraw up to $10,000 penalty-free for a first home.
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Qualified Acquisition Costs Qualified acquisition costs include the following items.
§ Costs of buying, building, or rebuilding a home. § Any usual or reasonable settlement, financing, or other closing costs
First-Time Homebuyer A first-time homebuyer is, generally, any individual (and his or her spouse, if married) who had no present ownership interest in a main home during the 2-year period ending on the date the individual acquires the main home to which these rules apply.
Date of Acquisition The date of acquisition is the date that:
§ The first-time homebuyer enters into a binding contract to buy the main home to
which these rules apply, or § The building or rebuilding of the main home to which these rules apply begins.
Avoidance of the Pre 59½ Distribution Penalty If they make a withdrawal prior to age 59½ from their traditional IRA they must pay an additional tax of 10%. This tax is 10% of the part of the distribution that they have to include in gross income. It is in addition to any regular income tax on the amount they have to include in their gross income. However, if they stringently adhere to one of three withdrawal methods that the IRS approves of, they may make withdrawals prior to age 59½ and avoid the Premature Distribution Penalty Tax.
An Annuity Payout Option They can receive distributions from their traditional IRA that are part of a series of substantially equal payments over their life (or their life expectancy), or over the lives (or joint life expectancies) of them and their beneficiary, without having to pay the 10% additional tax, even if they receive such distributions before they are age 59½. They must use an IRS-approved distribution method and they must take at least one distribution annually for this exception to apply. One IRA-approved method is known as the "life expectancy method" Unlike for minimum distribution purposes, this method, when used for this purpose, results in the exact amount required, not the minimum amount. The payments under this exception must continue for at least 5 years, or until they reach age 59 ½, whichever is the longer period. This 5-year rule does not apply if a change from an approved distribution method is made because of the death or disability of the IRA owner. The payment must be calculated on the life or life expectancy of the recipient of the IRA and payments be made no less frequently than annually. If the payments under this exception are
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changed before the end of the above required periods for any reason other than the death or disability of the IRA owner, he or she will be subject to the 10% additional tax. For example, if they received a lump-sum distribution of the balance in their traditional IRA before the end of the required period for their annuity distributions and they did not receive it because they were disabled, they would be subject to the 10% additional tax. The tax would apply to the lump-sum distribution and all previous distributions made under the exception rule. There are two other IRS-approved distribution methods that they can use. They are generally referred to as the "amortization method" and the "annuity factor method." These two methods are complex and require the assistance of a tax professional, for more information about these methods see IRS Notice 89-25 in Internal Revenue Cumulative Bulletin 1989-1.
State Premium Taxes on Variable Annuities Some states impose a "State Premium Tax" against either the Accumulated Value of the variable annuity or the Purchase Payments. Companies deduct these taxes as incurred according to state regulations. State tax laws change, so check with the company issuing your variable annuity contract for the most current tax status.
Examples:
States with A Premium Tax on VA Investment
State Qualifying Non-Qualifying
Maine 0.00% 2.00%
South Dakota 0.00% 1.25%
Wyoming 0.00% 1.00%
States with A Premium Tax on Annuitized Contracts
State Qualifying Non-Qualifying
California 0.50% 2.35% Nevada 0.00% 3.50% West Virginia 1.00% 1.00%
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1035 Exchanges
1035 refers to a provision in the tax code that allows for the direct transfer of accumulated funds in a life insurance policy, endowment policy, or annuity policy to another life insurance policy, endowment policy or annuity contract without creating a taxable event. Title 26, Subtitle A, Chapter 1, Sub chapter O, Part III, Section 1035 states that "no gain or no loss shall be recognized on the exchange" of life insurance policy for another life insurance policy or endowment or annuity policy...an endowment for another endowment with a maturity no later than the maturity date of the endowment being replaced...an annuity policy for another annuity policy.
Life Insurance to Annuity Robert purchased a life insurance policy 20 years ago with a death benefit of $100,000 the premium was $1,000 a year and has a cash surrender value of $75,000. Robert is now retiring and has adequate life insurance provided by another life insurance policy. Robert doesn't need any income at this time but has decided to purchase an annuity paying a guaranteed rate of interest at 6.0%. Robert doesn't want to "cash in" in his life insurance since there would be a "gain" which would be taxed. The value of the policy is $75,000, the premiums paid total $20,000, and if Robert "cashes in" his policy, the gain of $45,000 would be subject to taxation. The solution is to "cash in" his life insurance policy by executing a "1035 Exchange". Robert would fill out a 1035 Exchange form which would direct the life insurance company to "cash in" his policy and send the $45,000 directly to the company which is issuing his annuity policy. In this way, there would be no taxes due, and further, the "cost basis" of $20,000 would become the "cost basis" of his annuity contract.
Annuity to Annuity 1035 exchanges are used with annuity or variable annuity contracts in the same way to transfer the funds of one annuity to that of an annuity paying a higher rate of interest. It is suggested that before someone does this that they check to see if there would be any penalties or surrender charges imposed before they "cash in" an existing annuity contract.
Partial 1035 Exchange In an outcome that surprised some, the Tax Court recently held that a proper Section 1035 exchange had taken place when an annuity holder transferred only a portion of the funds in one annuity to a second newly-issued annuity. This approval of a "partial" exchange may increase the planning opportunities typically associated with Section 1035 tax-free exchanges.
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In its opinion, the court examined the regulations for Section 1035, legislative history, and a case dealing with the exchange of Section 403(b) annuities and concluded that there is no requirement that the entire annuity contract be exchanged. The court's opinion stated that the only requirements under the applicable regulations are that the contracts be of the same type (e.g., an annuity for an annuity) and that the obligee under the two contracts be the same person.
“One for Two” 1035 Under Section 1035, exchanges are not actually tax-free, but tax-deferred. The investment in the original contract is carried over to the new contract, so the gain is deferred until payments begin or a withdrawal from the policy is made. An owner of a deferred annuity requested a ruling on whether the exchange of one annuity contract for two annuity contracts would qualify as a Section 1035 exchange. The two replacement contracts were to be issued by the same company that issued the original annuity contract. The exchange would not have resulted in a change of owner or annuitant. The reason this was an issue is because the language of Section 1035 says that an exchange can be made of "an annuity contract for an annuity contract," which might lead some to believe it means that one contract may be exchanged for only one new contract. In the case at hand, one of the new annuities was to be a variable annuity. The other was to have a "guaranteed minimum income" feature so that regardless of the performance of the underlying investments of the annuity, a minimum amount will be paid out each month. In its ruling, the IRS pointed out that if two or more annuities were purchased with the same consideration, the annuities would be treated as one annuity contract for income tax purposes. The revenue service also said that Section 1035 is similar to Section 1031, which governs exchanges of other types of property such as exchanges of real estate. Under Section 1031, one piece of property may be exchanged for multiple pieces of property of a tax-deferred basis, such as one piece of real estate for two or more. Therefore, the IRS concluded that the proposed exchange would qualify for Section 1035 treatment, and that the two new annuity contracts would be treated as one contract for income tax purposes. Finally, the IRS ruled that any transfer of funds between the two new annuities would not be treated as a taxable distribution from the annuity. The ruling for this is Private Letter Ruling 200243047.
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Chapter 6 Objectives Upon completion of this section, you will:
§ Gain increased understanding about what charitable gift annuities are and how they work. § Learn about an annuity’s role in structured settlements. § Discover through “split annuities” how to combine attributes of two annuity types to
achieve a specific client’s retirement goals.
Chapter 6 Special Usage
While volumes have been written about the many specialized uses of annuities and entire courses dedicated to the specifics and details of each usage, we provide an overview of three of the most common and widely used strategies to provide you with a fundamental awareness of them.
Charitable Gift Annuities Many nonprofit organizations that had depended upon federal funding for a large part of their operating budgets are experiencing reductions from that source. Income tax levels are becoming increasingly punitive. People are looking for legitimate forms of tax relief. Additionally, more and more Americans are facing the probability that Social Security will be a completely inadequate "safety net" for their retirement. These concerned people are looking for tax-favored ways to augment their future retirement incomes. Charitable gift annuities (CGAs) provide one solution to these concerns. A gift annuity offers immediate tax relief, and has the potential to provide some tax-free retirement income. In exchange for the gift contributions made to a charity, the charitable institution guarantees a retirement income, either immediate or deferred, which can last for the entire lifetimes of the donor and spouse. In addition to the economic advantages, the donor can experience the satisfaction of seeing a part of the proceeds of a gift put to immediate use in a charitable institution, which is dear to his or her heart. A CGA, which is reinsured with an immediate annuity, provides the charity with the advantage of immediate access to a significant portion of its gift proceeds.
How Do Charitable Gifts Work? A CGA (Charitable Gift Annuity) is one of the easiest forms of planned giving. In exchange for an immediate gift to a legitimate 501(c)(3) charity, the donor is promised a specified lifetime income. The exact amount of that gift is agreed upon at inception. Typically, the life income goes to the donor or is shared as a 100 percent joint and survivor option to the donor and spouse.
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The arrangement is that simple. There is an agreement of understanding between the donor and the charity. The charity’s stability and reputation provide peace of mind to the donor. If the charity ceased to make the agreed upon payments, the donor would be a primary creditor against that institution. Obviously, a century-old establishment such as a nonprofit hospital or major community church would have an easier time attracting a CGA donor than would a recently established organization.
An individual may make a "gift" or "donation" to a nonprofit or educational organization and in return receive an income for life and multiple tax deductions.
The Gift and Tax Deduction An individual or couple may fund a charitable gift annuity with cash and marketable securities.
Cash Cash donations to fund a charitable gift annuity entitles them to claim a charitable income tax deduction in an amount of up to 50% of their adjusted gross income. If, in the year, they make the gift and the gift is greater than 50% of their income they may carry the balance forward for up to five years.
Securities Securities used to fund a charitable gift annuity provide the donor with a unique advantage. If the securities have been held for more than one year the charitable income tax deduction is based on the market values of the securities. They may claim a charitable income tax deduction of up to 30% of their adjusted gross income. If, in the year, they make the gift and the gift is greater than 30% of their income they may carry the balance forward for up to five years.
The Income Once the gift has been made they can elect to defer the income or chose to have it begin immediately.
Guaranteed Income One advantage of a charitable gift annuity is that it creates a guaranteed income at a guaranteed rate of return. Most organizations use the table set by the American Council on Gift Annuities (ACGA) to determine the maximum rate that can be paid to them.
Non-Taxable Income Based on their life expectancy, a part of each payment for a limited time period is not taxable, this is known as the exclusion allowance.
Examples of a Charitable Gift Annuity
A Gift based on a Single Life Mr. Bill Samuels who is 70 years old has decided to donate $50,000 to his college as a gift annuity. The reasons Mr. Johnson chose a gift annuity are as follows:
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• The college receives a gift of $50,000 • Mr. Johnson receives a guaranteed lifetime income • Mr. Johnson receives a immediate tax deduction • Mr. Johnson's $50,000 gift is no longer part of his estate
When Mr. Johnson makes the gift to the college he will receive a guaranteed annual income of $1,000 for the balance of his life, this was based on the rate recommended by the American Council on Gift Annuities (ACGA). This amount is based on the IRS discount rate of 1.8% for the month of April 2017.
In the year in which he makes the donation to the college, he will receive a tax deduction in the amount of $19,857. Each month the IRS sets the discount rate - check with the IRS for the current discount rate (Example: 1.8% for the month of April 2017). When Mr. Johnson receives his annual income of $1,000 he pays taxes only on a portion of this income, $660 of the $1,000 is not taxable over his life expectancy.
A Gift based on Two Lives…
Mr. and Mrs. James Allison have chosen to make a $50,000 gift to Mrs. Allison's college. However, they would like the guaranteed income to be paid to either Mrs. Allison or Mr. Allison for as long as either is living. When Mr. Allison (older beneficiary) makes the gift to the college, Mr. and Mrs. Allison receive a tax deduction in the amount of $19,857. The annual income paid to Mr. Allison and Mrs. Allison is $1,000 that will continue to Mrs. Allison should Mr. Allison pre-deceases Mrs. Allison. This annual income will continue until Mrs. Allison's death. When Mr. and Mrs. Allison receive their annual income of $1,000, Mr. and Mrs. Allison will pay taxes only on a portion of the income, $550 of the $1,000 will not be taxed over their joint life expectancy.
Structured Settlements
From time to time, you may encounter a person who received, or is about to receive, a large settlement of a personal injury lawsuit. A structured settlement is an arrangement in which the injured party (plaintiff) agrees to accept a series of periodic payments either over a lifetime or for a fixed number of years, rather than pursue a lump-sum settlement. The desirability of the arrangement is obvious where the injured party is a child or otherwise incompetent to manage a large lump sum, but many competent adults also accept a structured settlement because of income tax considerations.
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Tax Advantages Let’s look at an example to illustrate the tax advantages of a structured settlement. Assume Mary receives $1 million as a lump sum settlement for personal injuries. The $1 million itself is tax-free under the IRS Code, but Mary wants to invest in order to provide an income to live on. Suppose she buys an investment that produces an 8% return, or $80,000 per year. Depending on where Mary lives, the combined local, state, and federal income tax on her annual income could be in the 30-40% range. On the other hand, if Mary had agreed to accept a properly arranged structured settlement of, say, $100,000 per year for life, the entire amount received is income tax-free under Code section 104(a)(2), according to Revenue Ruling 79-220, 1979-2 C.B. 74.
A Negotiated Settlement A structured settlement is arranged through negotiations between the injured party and the defendant, or more likely, the defendant’s casualty insurer. (It’s important to note the desired tax effects aren’t available if the plaintiff has either actual receipt or constructive receipt of a lump sum. If the plaintiff has the settlement check in hand, there is no doubt actual receipt has occurred.) Constructive receipt occurs when a plaintiff has the money available or when it is set-aside for her. Thus, if the plaintiff is offered the choice of a lump-sum settlement or a structured settlement, the IRS may take the position the plaintiff had constructive receipt of the money. If the defendant’s casualty insurer agrees to make periodic payments to the plaintiff, it could buy an annuity to fund the payments, but it would have to be the owner of the annuity. Under no circumstances can the plaintiff be the owner of the annuity without triggering the constructive receipt rule. As a practical matter, casualty insurers won’t buy an annuity and make periodic payments themselves. First, the casualty insurer desires to "close the books" on claims and doesn’t want to keep a file open for years to come. Secondly, the casualty company can’t deduct the premium cost of the annuity in the year of purchase; instead, the company must amortize the cost of the structured settlement over the term of the annuity, and deduct the payments when made to the plaintiff.
Qualified Assignments In reality, structured settlements are carried out through the use of a "qualified assignment." An assignee, typically an affiliate or subsidiary of a life insurance company, assumes the obligation of the casualty company to make periodic payments to the plaintiff, and in consideration, receives a single premium payment from the casualty company. The plaintiff agrees to release the casualty company from liability and looks solely to the assignee for periodic payments. The casualty company then deducts the entire premium payment in the year made as a business expense and clears its books. This arrangement is what is meant when the term structured settlement contract or structured settlement annuity is used. An agent can’t expect to sell an ordinary deferred annuity to either the plaintiff or casualty company as part of a structured settlement. In order to make a commission, an agent must be
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licensed with a structured settlement company and sell that company’s contract to the casualty company to cover a settlement previously negotiated with the plaintiff. Of course, if the plaintiff has a lump-sum settlement check in hand, the agent may sell a deferred annuity to her, but she must be made aware that distributions will be subject to the usual annuity taxation rules, including a 10% penalty for withdrawals prior to age 59½.
Split Annuities A Split Annuity is not an annuity policy but a combination of two annuity products…a fixed period immediate annuity and a single premium tax deferred annuity. They are structured in such away as to produce immediate tax-advantaged income for a guaranteed period of time and to restore their original principal at the end of that time period. It’s a contract by which the annuity owner "splits" his or her initial premium into two pieces and puts part of the premium into a fixed deferred annuity with a guaranteed interest rate for a given term, and puts the other part into an immediate annuity that pays an income for that same term. It is usually structured where the deferred annuity grows back at the end of the guaranteed period to the total deposit originally invested, while receiving a guaranteed income from the immediate annuity throughout that same time period.
Advantages of a Split Annuity
Dependable Income The Immediate Annuity can supplement one’s income by providing them with a safe, predictable, and guaranteed cash flow. Depending on their income needs, the Immediate Annuity can generate a stream of monthly income anywhere from five to twenty years.
Tax-Advantaged Income Since a significant portion of their monthly income from the Immediate Annuity is considered a return of their original investment, it is tax-advantaged. In our example below, 81% of their monthly income payments would be Tax-Free.
Tax-Deferred Growth and Principal Preservation The Deferred Annuity portion of the split-annuity concept offers tax-deferred growth and they earn an interest rate that historically has been higher than average CD rates. In addition, their original principal is restored at the end of the guaranteed period that allows them to start the process over again at prevailing interest rates. The funds placed in the Single Premium Deferred Annuity policy are available for emergencies with limitations.
Plan Limitations The limits placed on the use of a split annuity are the issue ages of the policies, usually age 0-85 for non-qualified funds and 0-70 for qualified funds. The immediate income periods range from 3 to 20 years.
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Example of a Split Annuity
$100,000 Total Funds are SPLIT
(for 3.125% rate example, divide everything by 2)
Immediate Annuity $38,430 at 6.25%
Deferred Annuity
$61,570 at 6.25%
Monthly Income
$485.37 will grow to
Annual Income $5,824.48 Yr. 1 $65,418
Yr. 2 $69,507 for 8 years for which Yr. 3 $73,851
Yr. 4 $78,466 82%
is not taxed Yr. 5 $83,371 Yr. 6 $88,581
Total Income before Taxes $46,595.83
Yr. 7 $94,118 Yr. 8 $100,000
Original Principal
$100,000
Please note that the illustration is based on a guaranteed interest rate of 6.25% for 8 years. Withdrawals from an annuity prior to age 59½may result in a 10% penalty tax imposed by the IRS. Annuities are not FDIC insured.
