Deferred Annuities

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Barry Barnitz
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Deferred Annuities

Post by Barry Barnitz » Wed Mar 28, 2007 11:22 am

(please post additional contributions in the Suggestions For Librarians Topic)

A Deferred Annuity is an insurance contract that delays payments of income, installments or a lump sum until the investor elects to receive them. This type of annuity has two main phases, the savings phase in which you invest money into the account, and the income phase in which the plan is converted into an annuity and payments are received. A deferred annuity can be either variable or fixed. Earnings within the contract are tax deferred, and are taxed upon withdrawal at income tax rates (similar to qualified retirement plans) and share with these plans the 10% early penalty tax for withdrawals made prior to age 59 and 1/2.

bob90245 offers the following:

I have put together this primer on annuities. (Source is attributed at the end.)

Types of Annuities

Deferred Annuities are used to accumulate assets. Funds will grow at a rate that can be either fixed or variable.

Fixed Annuity
The money you put in a fixed annuity earns interest at a rate that is guaranteed for a specific period of time—ranging from one to five years or more, depending on the terms of the contract. When that period ends, a new rate may take effect—or the old rate may be offered again.

Variable Annuity
With a variable annuity, your money is put in subaccounts that are invested in stock and bond funds. The return on your investments is subject to the risk of market fluctuation. Your total account value depends on how much risk you take, the performance of the subaccounts, and what charges and fees are deducted.

Immediate (Income) Annuities [note:see the Reference Library Topic Immediate Annuities] are used to convert a lump sum into an income stream (regular payments). If the income stream is fixed, it is considered a fixed immediate annuity. Some fixed immediate annuities are offered with inflation-adjusted payments or graded payments that rise at a fixed rate, of for example, 3% annually. However, these options reduce the initial payment received but with the anticipation that payments will grow steadily over time.

If the income stream is variable, it is considered a variable immediate annuity. Like deferred variable annuities, your money is put into subaccounts. These subaccounts can be invested in stock or bond funds. Payments will fluctuate based on the underlying subaccounts. With funds invested in stocks, it is possible that payments could grow at a rate higher than can be achieved by fixed immediate annuities.

Source: The Individual Annuity: A Resource in Your Retirement (pdf)

The following definitions can help explain the technical terminology associated with Annuities.

Annuity Unit
Annuitization Method
Assumed Interest Rate (AIR)
Exclusion Ratio
Fixed Annuity
Guaranteed Minimum Accumulation Benefit (GMAB)
Guaranteed Minimum Income Benefit (GMIB)
Guaranteed Lifetime Withdrawal Benefit (GLWB)
Guaranteed Minimum Withdrawal Benefit (GMWB)
Inflation Protected Annuity (IPA)
Joint and Survivor Annuity
Indexed Annuity
Life With Guaranteed Term
Mortality and Expense Risk Charge
Straight Life Annuity
Surrender Fee
Systematic Withdrawal Schedule
Variable Annuity


Sales practices associated with Variable Deferred Annuities are often clouded with conflicts of interest as much of the product is sold through commissioned agents. Insurance benefit charges make annuities a higher cost investment medium than other investment vehicles. No-load, lower cost Variable Annuities are available from Vanguard, TIAA-CREF, and Fidelity.

SEC: Variable Annuities: What You Should Know
NASD : Variable Annuities: Beyond The Hard Sell


Tax free exchanges of non-qualified Annuity contracts are permitted through what is known as a Section 1035 Exchange.

Transfers are quantifiable decisions. The following paper provides guidance for determining the suitability of a transfer.

1. Exchanging Variable Annuities: An Optional Test For Suitability by Moshe Milevsky and K. Panyagometh (2003)

In this paper we offer a novel method of assessing whether exchanging one variable annuity (VA) policy for another, destroys or adds value from a purely economic perspective. We do this by decomposing the policy into a portfolio of financial options and then use an option pricing model to compute the difference in aggregate value between the embedded options in the new and old VA. Our paper illustrates this
approach with a variety of case studies using a software implementation that is available on the journal’s website. We also draw some general conclusions about the conditions under which a VA exchange is likely to be suitable. Overall, we believe that our methodology is a non-biased and objective technique for mitigating some of the long-standing concerns about excessive churning of VAs.

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Deferred Annuities: Papers

Post by Barry Barnitz » Wed Mar 28, 2007 12:00 pm


1. Household Ownership of Variable Annuities by Jeffrey R. Brown and James M. Poterba (2005)

Variable annuities have been one of the most rapidly growing financial products of the last two decades. Between 1996 and 2004, nominal sales of variable annuities in the U.S. more than doubled, from $51 billion to $130 billion. Variable annuities now account for approximately nearly two thirds of annuity sales. The investment returns associated with variable annuities resemble those from mutual funds, and variable annuity buyers can select among a range of asset allocation options. Variable annuities are considered insurance products under the tax law, so buyers are not taxed on their investment returns until they make withdrawals from their variable annuity accounts. This paper describes the tax treatment of variable annuities, presents summary information on their ownership patterns, and explores the importance of several distinct motives for household purchase of variable annuities. The discussion of tax treatment examines the impact of the 2001 and 2003 tax bills on the relative tax treatment of variable annuities and other financial products. Household data from the 1998 and 2001 Survey of Consumer Finances shows that variable annuity ownership is highly concentrated among high income and high net wealth sub-groups of the population. Variable annuity ownership is less concentrated, however, than ownership of several other types of financial assets. Evidence on the role of tax incentives in encouraging ownership of variable annuities is mixed. The probability of owning a variable annuity rises with the marginal tax rate throughout most of the income distribution, but it is lower for households in the top tax bracket than for those with slightly lower tax rates.

2. . Variable Annuities versus Mutual Funds: A Monte Carlo Analysis of the Options by Milevsky, M.A. and Panyagometh, Kamphol, (2001)

This paper quantifies the impact of return uncertainty when measuring the relative benefits of mutual funds versus variable annuities by calculating the certainty equivalents of utility. This paper points out that the possibility of an investment loss endows the holder of the mutual fund with a 'real option' to harvest those losses and this 'real option' has value and must be factored into any decision in advance.

Our main practical observation is that although we find that low-cost Variable Annuities are indeed superior to low-cost Mutual Funds for investors with a long time horizon, the critical threshold is at least 10 years for typical levels of risk aversion. If, however, we ignore the embedded options, the erroneous break-even horizon drops to 5 years. The stochasticity increases the break-even horizon.

Note: changes in tax rates since this paper was published have extended the break-even horizons for comparative returns]

3. Who Should Buy A Nonqualified Tax Deferred Annuity? by William Reichenstein (2001)
This study describes the structure on nonqualified tax-deferred annuities and examines when they are in the best interest of individual investors as savings vehicles. It concludes that, unless they are concerned about creditor protection, few individuals should consider saving in an annuity. Those few must decide between an annuity and a mutual fund held in a taxable account. In general, young investors with long investment horizons should consider annuities. Costs are a critical factor, however. Most annuities have high costs compared to mutual funds. This study concludes that investors fare better with either low-cost annuities or low cost mutual funds.

4. Retirement Planning: Annuities and When They Make Sense by William Reichenstein, AAII Journal, July, 2003
Conclusions from this study can be easily summarized:
• Individuals should only consider buying a non-qualified annuity if they are saving for retirement and have already fully funded their Roth IRAs and qualified retirement plans such as 401(k) plans.
• Individuals should seldom consider buying an annuity and placing it inside a qualified plan.
• Knowledgeable individuals who want to save more for retirement than is allowed in Roth IRAs and deductible pensions should decide between saving in a low cost non-qualified annuity and a low-cost mutual fund.
• Low-cost annuities can make sense for bond investors and active stock investors with long investment horizons, especially if they expect to be in a lower tax bracket during retirement.
• The typical annuity with expense ratios approaching 2% or higher is not in the best interests of investors.

Contributed by Dale Maley

5. Non-qualified Annuities in After-tax Optimizations by William Reichenstein (2005)
The analysis suggests that the people who should be most interested in holding stocks in annuities are those who trade too frequently to qualify for preferential capital gain tax rates. Finally, this study may be the first to demonstrate that an individual investor bears more risk when an asset is held in an annuity instead of taxable account, and it considers the implications of this conclusion for optimal asset-allocation and asset-location decisions.

6. The New Variable Annuity by Colin Devine, Heather L. Hunt, and Keith Walsh (2004)
Recent variable annuity sales growth has been excellent for insuriers offering guaranteed living benefit features. But what is good for the consumer may not be good for the insurer. We believe these popular new products could pose as much, if not more, risk as guaranteed minimum death benefits in a bear market.

Variable annuity guaranteed living benefits (VAGLBs) could provide an appealing income stream for the 77 million baby boomers who face the risk of "living too long" rather than "dying too soon" should their retirement savings prove insufficieint. We look for employers to begin offering these products to their employees to help them secure post retirement funds from 401(k) and other types of defined contribution plans.

For insurers, VAGLBs present two sets of potential challenges. First, the liability could significantly surpass the value of underlying subaccount assets in a protracted market downturn. Second, equity market volatility would flow through to regulatory capital even in short-term market corrections. This can hinder credit ratings and overall capital adequacy.

There are three basic types of VAGLBs-- GMWBs, GMIBs, and GMABs

7. Asset Allocation and the Transition to Income: The Importance of Product Allocation in the Retirement Risk Zone by Moshe Milevsky and Thomas Salisbury (September 2006)
As Canadians transition from years of saving and wealth accumulation to generating cash-flow and income in retirement, they must voyage through a fragile period in which poor investment returns can devastate the sustainability of their portfolio. Anyone who retired in the early part of this decade -- and started withdrawing money from a deteriorating equity portfolio -- understands these risks first hand. Their finances might never recover.

In this report we focus analytic attention on this fragile period by quantifying the impact of poor investment returns in the retirement risk zone. We illustrate how an early bear market during retirement can double or even triple the ruin risk, compared to experiencing the same poor investment returns later on. The years just prior to retirement are equally important.

Furthermore, this risk cannot be avoided by attempting to time the market nor can it be mitigated by transitioning to a conservative (i.e. bond) asset allocation. Rather, our main argument is to advocate the role of new and innovative FinSurance products that create downside protection in the retirement risk zone. An additional benefit of insurance for a retirement portfolio is that it allows investors to comfortably and rationally take on more equity market exposure than they would have otherwise, in the absence of this guarantee.

In sum, although conventional wisdom dictates that asset allocation explains the greater part of investment performance in the accumulation phase, we believe that product allocation will determine success in the
retirement income phase.

8. An Overview of Equity Indexed Annuities by Craig McCann, PhD and Dengpan Luo, PhD (2006)
Equity-indexed annuities are complicated investments sold to unsophisticated investors without the regulatory safeguards afforded to purchasers of similar investments. If brokers and agents told investors of the effect equity-indexed annuities’ shaving of index returns and extraordinary costs the market for these products would dry up.
Ironically, both the SEC and the NASD caution investors to review and understand the impact on likely returns of the myriad equity-indexed annuity features. No registered rep, insurance broker, or retail investor, and precious few finance PhDs, could understand these products. The net result of equity-indexed annuities’ complex formulas and hidden costs is that they survive as the most confiscatory investments sold to retail investors.
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Pricing Variable Annuity Benefits

Post by Barry Barnitz » Wed Mar 28, 2007 12:27 pm


The following papers are technical. They deal with the economic pricing of Variable Annuity benefit riders. The papers allow one to measure the cost/benefit trade off for each insurance benefit.

1. The Titanic Option: The Pricing of the Guaranteed Minimum Death Benefit in Variable Annuities and Mutual Funds by Moshe Milevsky and Steven Posner
The authors use risk-neutral option pricing theory to value the guaranteed minimum death benefit (GMDB) in variable annuities (VAs) and some recently introduced mutual funds. A variety of death benefits, such as return of- premium, rising floors, and “ratches,” are analyzed. Specifically, the authors compute the fair insurance risk fee, charged to assets, that funds the embedded option. The authors derive analytic option prices for a simplified exponential mortality model and robust numerical estimates in the case of a properly calibrated Gompertz model. The authors label this contingent claim a Titanic option because its payoff structure is in between European and American style but is triggered by death. The authors’ main objective is to compare theoretical estimates against a cross-section of insurance risk charges, as reported by Morningstar, Inc. The authors’ main conclusion is that a simple return-of-premium death benefit is worth between one and ten basis points, depending on gender, purchase age, and asset volatility. In contrast, the median Mortality and Expense risk charge for return-of-premium variable annuities is 115 basis points. Presumably, the remaining markup can be attributed to profits, model imperfections, or, more cynically, to an implicit payment for the tax-deferral privilege.

2. Static and Dynamic Valuation of Guaranteed Minimum Withdrawal Benefits by Moshe A. Milevsky and Thomas S. Salisbury (2004)
We value a guarantee available to retail investors on many variable annuity (VA) policies called a Guaranteed Minimum Withdrawal Benefit (GMWB). First, we take a static approach that assumes individuals behave passively in utilizing the guarantee and show the product can be decomposed into a Quanto Asian Put plus a generic term-certain annuity.
The opposite dynamic approach leads to an optimal stopping problem akin to pricing an American put option, albeit complicated by the non-traditional payment structure. Our main result is that the cost of providing a GMWB ranges from 73 to 160 basis points of assets per annum. In contrast, recent products are only charging 30 to 45 basis points. We suggest a number of reasons for the apparent under-pricing of this feature in a typically overpriced VA market.

3. Guaranteed Minimum Withdrawal Benefit in Variable Annuities by Dai, Min, Kwok, Yue Kuen and Zong, Jianping (Feb 2007)
We develop a singular stochastic control model for pricing variable annuities with the guaranteed minimum withdrawal benefit. This benefit promises to return the entire initial investment, with withdrawals spread over the term of the contract, irrespective of the market performance of the underlying asset portfolio. A contractual withdrawal rate is set and no penalty is imposed when the policyholder chooses to withdraw at or below this rate. Subject to a penalty fee, the policyholder is allowed to withdraw at a rate higher than the contractual withdrawal rate or surrender the policy instantaneously. We explore the optimal withdrawal strategy adopted by the rational policyholder that maximizes the expected discounted value of the cash flows generated from holding this variable annuity policy. An efficient finite difference algorithm using the penalty approximation approach is proposed for solving the singular stochastic control model. Optimal withdrawal policies of the holders of the variable annuities with the guaranteed minimum withdrawal benefit are explored. We also construct discrete pricing formulation that models withdrawals on discrete dates. Our numerical tests show that the solution values from the discrete model converge to those of the continuous model.

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