Retirement Planning Global- Chapter-4

Chapter-4 Potential Sources of Retirement Cash flow Learning Outcomes Upon completion of this chapter, the student will be able to:  Identify details to collect of a client’s potential retirement cash flow sources  Analyze retirement benefits provided by the government  Analyze retirement benefits provided by employers  Explain how annuities are used to provide retirement cash flow Topics  Pension funds  Government-sponsored  Defined benefit plans  Employer-sponsored  Defined contribution plans  Types of non-pension employee retirement benefits  Individual retirement plans  Annuities  Types of annuities  Settlement and pay out options Introduction Ancient Roman Emperor Augustus (from 27 BC until AD 14) wanted to guarantee the loyalty of his soldiers. To help ensure this, he offered a pension to people in the army with at least 16 years of service. Payment was to be in cash or land at a rate of 12 times their annual salary. As a result, military wages and pensions absorbed half of Rome’s tax revenues. The emperor would not be the last person to underestimate the cost of providing retirement benefits (The Economist, 2016). This problem is still continuing around the world today and is largely the result of defined benefit pension plans. We all know longevity has increased and return on investments has fallen down resulting in greater difficulty funding the guaranteed retirement benefits. CFP Level 2: Module 1 – Retirement Planning Page 1

In this chapter we will explore some of the retirement benefits provided by governments and employers, along with ways in which annuities may be used to fund retirement cash flow. Pension Funds There are two primary types of pension plans: defined benefit (DB) and defined contribution (DC). Defined benefit plans promise to pay a specified benefit to qualified retirees. Defined contribution plans do not guarantee a retirement benefit. They provide a sum of money which the retiree can use to fund retirement cash flow based on amounts the individual has contributed, employer contributions, and investment return rates. Often, DB plans do not require any contributions from individuals. Accounts are fully funded by the sponsor (e.g., government and/or employer). Usually, DC plans require participants to contribute to the plans. In fact, without participant contribution, it is possible the individual will not accumulate any money in the plan. Some countries offer fully-funded DB plans (sometimes also known as a social security program) while others have a combination of DB and DC plans, with both government funding and private/individual funding. We will look at government-sponsored pensions first and then those offered through employers. Government-Sponsored Just as Emperor Augustus provided a government-funded pension for people in the military, most countries provide some level of pension payments to citizens. The Organization for Economic Cooperation and Development (OECD) has produced a report on OECD and G20 national pension indicators for the last 10 years (OECD, 2016). The latest publication indicates significant pension reforms among many of the 42 countries covered in the report. OECD states that “the last decade has been a period of intense reform . . . with governments changing key parameters of their retirement income systems and, in some cases, proceeding to overhaul the design of pension schemes, often scaling down the ambition of public pensions and giving a larger role to funded DC retirement provision” (OECD, 2016, p. 9). Increasing the minimum retirement age to as high as 67 (occasionally higher) has been one of the major revisions in several territories (countries). These changes point to the problems we have identified of increased longevity and decreased investment returns. Unfortunately, increasing the age at which an individual can receive full retirement benefits does not also automatically increase the individual’s ability to continue working. Sickness and injury often force workers to step out of the workforce before they might otherwise desire to do so. Although many plans provide some level of benefits related to participant’s health, this has a potential impact on workers’ pension benefits, especially when they cannot continue working until reaching the increased retirement age. At the same time, a larger number of workers seem to be deciding to work CFP Level 2: Module 1 – Retirement Planning Page 2

for more years. This is largely due to a combination of decreased pension payments and the hope of greater income through increased employment earnings. Many public pension systems are pay as you go (PAYG) models. A PAYG model funds the pensions of retired people using contributions from those who are currently working. With more workers living longer and fewer younger workers paying into the system (largely due to decreased birth rates in many territories), many PAYG systems are experiencing some level of financial distress. Defined Benefit Plans Defined benefit plans guarantee a retirement income benefit, usually based on earned income and years of employment. When most people think of traditional pension plans, they are considering DB plans. The exact definition and plan parameters may be different among various countries/territories, but the basic principles will be similar. Benefits and the contributions necessary to provide them are determined by actuaries, and often updated annually. The DB plan’s guaranteed retirement benefit is at its core. That guarantee gives retirees an increased confidence level about how they will live during retirement, because they know the amount they will receive each month. They also know whether the amount will increase over the years as inflation causes purchasing power to decrease. Assuming the provider (e.g., government or employer), along with the pension plan, remains solvent, the retiree will have a base income on which to live. He or she may want to supplement the amount provided, but at least the foundational amount will be provided. DB plans may be public (i.e., social insurance or social security) or private (i.e., employer-sponsored), or a combination of the two. DB benefits usually are built around a formula that delivers a fixed amount or percentage benefit based on the worker’s salary and years in the plan. Plans may consider all annual income amounts or just the latest or highest paying years. For example, a plan formula may provide a benefit based on two per cent of the final year’s salary times the number of years in the plan. If a worker participated in the plan for 30 years and had a final salary amount of $100,000, the annual benefit would be two per cent of $100,000 times 30 or $60,000. Another option might provide something like $200 per month for each year of service, up to 25 years, for a total of $5,000 per month. Plans may also use modified formulas. Regardless of the formula used, all DB plans specify the amount the worker will receive at retirement. The amount may remain level throughout retirement or it may be adjusted periodically to compensate somewhat for the effect of inflation. CFP Level 2: Module 1 – Retirement Planning Page 3

Types of mandatory, retirement income programs include the following (Social Security Administration, 2016): Flat-rate pension: Uniform amount or one based on years of service or residence but independent of earnings. Earnings-related pension: Based on earnings. It is financed by payroll tax contributions from employees, employers, or both. Means-tested pension: Paid to eligible persons whose own or family income, assets, pension income, or a combination of these fall below designated levels. Flat-rate universal pension: Uniform amount normally based on age, residence and/or citizenship but independent of earnings. Provident funds: Employee or employer contributions are set aside for each employee in publicly managed special funds. Benefits are generally paid as a lump sum with accrued interest. Occupational retirement schemes: Employers are required by law to provide private occupational retirement schemes financed by employer and, in some cases, employee contributions. Benefits are paid as a lump sum, annuity or pension. Individual retirement schemes: Employees and, in some cases, employers must contribute a certain percentage of earnings to an individual account managed by a public or private fund manager chosen by the employee. The accumulated capital in the individual account is used to purchase an annuity, make programmed withdrawals, or a combination of the two and may be paid as a lump sum. Some plans base qualification on accumulating a minimum number of points. Each year contributions, based on a reference salary, are converted into points. Pension benefits are based on the number of points accrued. Points may also be accrued for periods of unemployment. Points are assigned a current value, which in turn, is used to determine a pension benefit. The number of pension points a person can accrue annually may be limited by regulation. Also, early retirement may cause a point reduction, which also reduces monthly benefit payments. Researching the systems that use points reveals a number of variables in how they are credited, accrued and applied. However, each system adds pension points and multiplies them by a pre-determined value so they can be converted into pension payments. Please note that employees are not responsible for investment results in DB plans. Regardless of what investments earn, the plan guarantees the benefit. This may mean the government or employer (whichever is sponsoring the plan) may have to increase plan contributions, but it should not impact CFP Level 2: Module 1 – Retirement Planning Page 4

the retiree’s benefits. Also notice that years of service frequently are part of the retirement benefit determination formula. This is likely to mean that employees with fewer years of service will automatically receive lower benefits during retirement. Fewer years of service (or plan participation) may result from ending working years sooner than normal or starting to work later than normal. It may also indicate that sometime during life the worker stopped working for a period. An example might be when a parent left the workforce to raise their children. Or, in the case of employer-sponsored DB plans, it could be a job or career change into the company in a client’s later working years. While some territories compensate for this by providing a regular benefit, others do not, and reduce retirement benefits correspondingly. There are two additional terms we need to define. The first is eligibility and the second is vesting. Employer-sponsored DB plans (and DC plans, too) require a minimum period before the worker is eligible to participate in the plan and begin accruing benefits. Often, this period is only a year or two, perhaps also requiring a minimum participation age (e.g., 21). Some plans may also include a requirement for a minimum number of hours to be worked during the year (e.g., 1,000). This requirement effectively eliminates workers who are seasonal or only work on a part-time basis. Prior to eligibility the worker does not begin accruing benefits. Vesting is the point at which accrued benefits belong to the individual. A participant may be fully vested after a year or two, or perhaps not for five to 10 years. Being vested does not mean the worker can actually receive the benefits immediately. That may have to wait until a specific age or numbers of years have passed. Vesting does mean that, whenever benefits can be paid, they will be due the participant. If the participant has accrued a vested benefit of $10,000, he or she will be paid the $10,000. As we indicated, payment may not come until the participant reaches age 65, but it will be made at that time. Sometimes vested benefits are given to the participant at any time when he or she terminates employment. The rules vary by plan and by territory, and may sometimes include a requirement for minimum years of participation. For example, a plan may require at least 10 years in the program before fully vesting. If a participant has fewer than the minimum required years, he or she will likely receive a reduced level of benefits. Cash Balance Plans: Defined benefit plans sometimes are structured as cash balance plans. These plans generally conform to the DB concept, but are set-up a little differently. A cash balance plan remains a DB plan, but it also shares aspects of a DC plan. As a result, a cash balance plan promises a pension benefit that is stated in terms of the accrued account balance. As a general description, a cash balance plan credits a participant’s account with an annual pay credit, which is based on a percentage of compensation. Additionally, the account has an interest credit, which can either be fixed or variable, CFP Level 2: Module 1 – Retirement Planning Page 5

and often is linked to an index or other conservative asset type. Investment risks continue to be borne by the employer, rather than the participant. Pension benefits are based on the age at retirement and the account balance. Accounts are sometimes called hypothetical accounts because they do not reflect actual contributions or investment returns. We should insert a cautionary note at this point. Even though DB plans promise to pay a specific retirement income benefit, there is no guarantee the full benefit will be paid. Recent years have seen more than one territory undergo significant financial distress. Although almost all territorial governments attempt to maintain pension and social insurance programs, deep enough financial stress may prevent them from doing so. Employers may also undergo significant financial difficulties resulting in pension benefit defaults. Most territories have programs designed to prop up such default, but consider what might happen if both the employer and the government were experiencing significant financial difficulty at the same time. We bring this up as a reminder to encourage clients to do as much of their own retirement planning as possible. If they were to accumulate enough money to fully fund their retirement, and their government pension also came through, what would be the downside? Certainly, they would have saved and invested money that they could have put to other uses during their working years. At the same time, during retirement, they will have more money to achieve any goals that require funding. They will be able to enjoy an increased standard of living, give money to charitable organizations and leave money to children and grandchildren. Contrast that scenario with one in which the client did not save for retirement because he or she was depending on government- provided benefits, but those benefits either were not paid or paid, but greatly reduced. Once a person begins living in retirement, it’s too late to start saving. Another reason to save money for retirement has to do with the age at which a person wants to retire. As mentioned, territories are increasing the minimum age at which full retirement benefits can be claimed. It’s becoming more common for the minimum age to be close to 66 or 67. If a client wants to retire before the minimum age allowed by the government, what can be done? If the worker has not saved any money for retirement, the answer likely is nothing . . . continues to work more years or accept a reduced benefit based on an earlier retirement age. On the other hand, if there are adequate funds, the individual can retire when desired using money he or she has accumulated to provide full retirement cash flow. Then, the retiree can begin receiving government benefits when they become available. Though, the only negative consideration to having too much money accumulated is that some programs reduce government-provided benefits when an individual has too much other income. If this is true in your territory, you will want to modify recommendations accordingly. We have been covering DB plans as if no participant contribution is required. While this may be true insofar as a requirement to make specific contributions, most plans do require some level of contribution (e.g., especially from employers, but also from participants). This often comes as a form of taxation, where individuals and/or employers are required to pay taxes to support pension plan CFP Level 2: Module 1 – Retirement Planning Page 6

benefits. For example, the Pay As You Go models which are funded by taxes and contributions from the current work force. An increasing number of DB plans are being supplemented by DC plans (e.g., hybrid plans). In other situations, DB plans are going away and being supplanted by DC plans. Governments sometimes offer both types of plan or just one or the other. Employer-sponsored retirement plans can be DB, DC or a combination, but are increasingly only DC plans. We will continue our coverage by looking at employer- sponsored DC plans next. Employer-Sponsored Defined benefit plans may have the longest history, but defined contribution and hybrid plans are overtaking them in application. One reason for this is the relative expense and complexity of most DB plans. A DC plan provides for and specifies contributions rather than benefits. Where DB plan participants know the retirement benefits they will receive, those in DC plans do not. They can know their account balance, but not the benefits that balance may provide. Benefits are determined by participant contributions, employer (or government) contributions and investment returns. Unlike DB plans, in most cases, participants are responsible for making investment decisions, and have to accept the results. DC plans are usually set-up so that each participant has an account, rather than all participants participating in one omnibus account maintained by the government, plan provider or employer[26]. Some plans convert accumulated amounts into pension payments while others simply provide the account balance and allow the participant to determine withdrawal amounts and timing. Whether or not the government contributes to the plan, it will almost certainly enact and enforce rules to oversee the plan and protect participant accounts. The types of DC plans, tax benefits and regulations vary from one territory to another, but the overall purpose and structures are similar. We can categorize DC plans into five categories (SSGA, 2015). 1. Open-architecture, broad-investment choice: Primarily used in US, UK, Ireland and Australia. The provider offers a large range of funds from which employers and employees can choose. 2. Government-mandated or collectively bargained guaranteed return: Primarily used in Germany and Belgium. Insurance contracts provide stated returns on participant savings. 3. Government- or state-approved provider: Primarily used in Chile and New Zealand. Employees have some degree of investment choice. Also used in Thailand, Hong Kong and Mexico. In these plans employers choose a licensed provider who then determines participant investment choices. 4. Personal pension brokered markets: Primarily used in the Czech Republic and Israel. Participants use account balances to purchase individual pensions through brokers. 5. State insurance model: Primarily used in Morocco and Pakistan. Participants pay into state- sponsored insured funds. CFP Level 2: Module 1 – Retirement Planning Page 7

Financial advisors working with multi-national companies and clients, who may live in multiple territories, should be aware of the potential plan differences. Multi-national employers generally want as much plan similarity as possible in the various territories in which they have employees. This is true, in part, to ease administrative issues and also because employees may move between territories as they continue working for the organization. Some areas, especially Europe, have been considering and implementing actual cross-border plans (Allianz Global Investors, 2013). However, a client’s DC plan in territory A may be fundamentally different from one held in territory B. Plan differences tend to revolve around the plan structure (as identified in the list above), as well as local regulations, employment law, tax implications, investment options, fiduciary responsibilities and plan benefits. The superannuation plan in Australia provides an example of one well-recognized and well-structured plan having several contribution options. Australian super plans require payment into the pension fund directly either on a pre-tax or after-tax basis (http://www.australia.gov.au/information-and- services/money-and-tax/superannuation). Notional Accounts: Most DC plans require actual contributions into separate accounts. However, four OECD territories – Italy, Norway, Poland and Sweden – have notional accounts (OECD, 2016, p. 124). China and Russia also use notional accounts in combination with defined contribution plans. According to OECD, notional accounts record contributions in the individual accounts and then apply a rate of return to the balances. The term notional comes from the practice of accounts existing only on the books of the managing institution. When the participant retires, the accumulated notional amounts are converted into a pension payment stream, based on life expectancy. These plans may be called notional defined contribution (NDC) plans. Each territory may have multiple types of DC plans. As an example, the U.S. has target benefit, money purchase, profit sharing, cross-tested, 401(k), several stock-based and stock option-based and Keogh plans. The U.K. has money purchase, executive pension, group personal, master trust (e.g., NEST, NOW pension), Self Invested Personal Pension (SIPP), Small Self-Administered Schemes (SSAS) and Stakeholder pension plans (Gov.UK, 2017). The exact nature of each plan is not important for our purposes, but knowing the variety that exists is worthwhile. You probably have more than one pension plan type in your territory, too. DC Plan Downsides The biggest downside of DB plans is the cost and administrative complexity. The upside is that participants have a guaranteed retirement income stream. DC plans offer greater variety, lower costs and less administrative complexity than DB plans, but the plan type also has a number of potential downsides. The biggest downside is related to its very nature. DB plans provide a defined retirement benefit. DC plans provide a plan into which participants can make contributions (along with employers and the government) from which they can create a retirement cash flow stream. However, the CFP Level 2: Module 1 – Retirement Planning Page 8

retirement cash flow is not guaranteed in most territories. Plan participants normally are responsible for making investment decisions. This can result in larger or smaller accounts even when contributions are of the same amount. When receiving retirement cash flow, DC plans usually do not control the amount or percentage a retiree can withdraw. This is great when it comes to flexibility and freedom of choice. However, it may also result in the retiree running out of money at some point during retirement. Most plans offer several investment options. While this is potentially beneficial, it also can produce participant concerns and questions. Often, when there are many options, participants get confused about how to invest. This may lead to them being vulnerable to those who suggest an investment scheme that does not benefit the participant. Usually, fewer investment options are preferable to too many. Even the fact that participants often can choose the degree to which they contribute is a potential problem. When times are tough and finances are low, people may choose not to contribute when given the option. This will help current cash flow. However, at retirement, it will also mean less money has been accumulated, resulting in lower than desirable cash flow levels. Some territories are addressing this problem by making contributions mandatory from both the employee and employer. DC plans sometimes offer ways to get some or all plan funds before retirement. Participants may access funds by taking a withdrawal or making a loan. Loans are supposed to be repaid, but withdrawals do not have to be. Even when a loan is repaid, the money was not producing any investment return while it was out of the account. Of course, this is also true of withdrawals. The biggest downside remains the lack of retirement cash flow certainty. Low contribution amounts and poor investment returns can combine to create a retirement cash flow environment that is less than satisfactory. From a public policy standpoint, this may result in people entering the public welfare system, because they do not have enough money to fund living expenses. As a financial advisor, you can provide a great service to clients by showing them how much they should contribute and the investment return to be targeted so they can achieve a retirement cash flow benefit on which they can live. Additional funding is nice, but not necessary. Having enough money on which to live should be considered mandatory. Types of Non-Pension Employee Retirement Benefits We will not explore this information in great detail, but you should know that some plans in many territories/countries provide non-pension retirement benefits. Healthcare probably is the biggest non- pension benefit. This can include regular medical benefits, extended care (long-term care), specialized, such as dental and eye care, along with other ancillary benefits. Sometimes benefits are provided directly by the government, paid for by taxes. Other times, employers offer extended benefits to retired employees. When employers provide the benefits, they may fund them through existing CFP Level 2: Module 1 – Retirement Planning Page 9

accounts established for this purpose or from the employer’s general account. Often benefit payments are provided on a hybrid basis by combining private with public/social insurance (government) benefits. Employers have been offering financial wellness benefits, too. Financial wellness refers to an individual’s overall financial condition. It can include savings, investments, debt, various types of insurance cover, funding tools (e.g., college, housing, etc.) and similar. Often, these benefits are being offered to existing employees, and some employers are extending the offer to retirees. Financial wellness can also include income tax and estate distribution guidance, both of which can be especially beneficial for retirees. Retirees may receive life insurance and death benefit payments, also. Benefits may include specific monthly payments to spousal and dependent children beneficiaries. Sometimes the employer provides an actual life insurance policy to the retiree. Usually, the retiree has made periodic premium payments, supplemented by the employer, over a period of time. At retirement, the policy becomes the full property of the retiree. Additionally, retirees may receive legal services, university tuition payments, transportation fees (e.g., public transportation), athletic facility access, and others. It’s difficult to identify all possible benefits, so you may want to explore the options in your territory. Individual Retirement Plans So far, we have focused on employer- and government-sponsored retirement benefits. In addition to these, individuals may be able to contribute to non-occupational individual retirement plans. Of course, anyone can save money in an account targeted to provide cash flow during retirement. In this section we will refer to those accounts that offer some degree of tax benefits, either during the contribution period, the distribution period, or both. Not all territories offer these plan types, but among those that do so in some form are: Bulgaria Canada Costa Rica Malaysia Singapore U.K. CFP Level 2: Module 1 – Retirement Planning Page 10

U.S. Several Eastern European, Scandinavian and South American territories (https://www.ssa.gov/policy/docs/ssb/v66n1/v66n1p31.html) Plans may be voluntary or compulsory and may be designed either to integrate with DB/DC plans or function on a stand-alone basis. They also have various names in each territory. For example, in Canada, you might see a Registered Retirement Savings Plan (RRSP) or Retirement Savings Plan (RSP). The UK has several types of Individual Savings Accounts (ISAs), while the US has traditional and Roth Individual Retirement Accounts (IRA). These are some examples, and plans in other territories go by different names. Each plan type shares a few similar characteristics, including tax deferral and regulatory limits and requirements. Individual retirement savings plans almost always provide some degree of tax savings. This is done to encourage individuals to use the plans to save money for the future. Some of the plans also allow for tax and/or penalty free withdrawals for certain pre-retirement expenses, such as purchasing a home or paying tuition or medical expenses. These retirement savings plans can provide tax-free or tax- deferred growth within the plan and initial deposits may be made on a tax-deferred basis as well. Plans also normally have annual contribution limits – whether or not the initial contribution has specific tax benefits. Contribution limits also may include specific account-type limitations. For example, UK ISA plans have four sub-plan types with each type having specific contribution limits. There is also a limit of the total amount that can be contributed to all plan types in a year. What types of investments can you use? That varies as well. Some accounts only allow cash, while others allow money to be invested in shares, stocks, annuities, and other options. Some plans limit certain asset types, such as real assets, commodities, option contracts, and similar. Plans that allow for stock/share investments often do not tax the growth (capital gain). When more than one provider offers plans, participants may be able to transfer from one account to another without tax implications. Usually, there are rules on how this may be done and how often. Also, it may be possible to make a temporary withdrawal, use the money, then re-deposit in the account without having to pay tax or penalties. As with the other areas, participants and their advisors should carefully review relevant regulations to ensure they do not inadvertently run afoul of requirements. It may be possible to incur on going penalties or even invalidate the plan by not following relevant regulations. Flexibility and control is another characteristic of many individual retirement savings plans. Plans provided through the government and employers often limit options around investments, beneficiaries, pre-retirement access to funds, vesting, contribution amounts, and perhaps other areas. Individual accounts usually provide the ability to bypass some or all of these limits. However, as we CFP Level 2: Module 1 – Retirement Planning Page 11

have seen, they come with their own limits, but those normally are less onerous than with government and employer plans. Question Broadly speaking, there are two primary types of pension plans: Defined Benefit (DB) and Defined Contribution (DC). Which of the following statements is most likely correct? a Defined benefit plans promise to pay a specific retirement income benefit, and there is a guarantee that the full benefit will be paid. b Where defined contribution plan participants know the retirement benefits they will receive, those in defined benefit plans do not. c Defined contribution plans are usually set-up so that each participant has an account, rather than all participants participating in one omnibus account maintained by the government, plan provider or employer. d Unlike defined contribution plans, in most cases, defined benefit participants are responsible for making investment decisions, and have to accept the results. Correct Answer C Explanation Defined contribution plans are usually set-up so that each participant has an account, rather than all participants participating in one omnibus account maintained by the government, plan provider or employer. Distractor #1 a Even though DB plans promise to pay a specific retirement income benefit, there is no guarantee the full benefit will be paid. Distractor #2 b Where DB plan participants know the retirement benefits they will receive, those in DC plans do not. Distractor #3 d Unlike defined benefit plans, in most cases, defined benefit contribution participants are responsible for making investment decisions, and have to accept the results. CFP Level 2: Module 1 – Retirement Planning Page 12

Annuities Annuities have been used as part of retirement funding for many years. They are an investment option rather than a retirement plan type, but because they provide some unique benefits, we are covering them separately. Before governments opened the door to various retirement plans, many people used annuities to provide cash flow during the retirement period. Annuities have a history going back to the Roman Empire (Ritchie, 2017). From the beginning, annuities represented an agreement between a buyer and seller whereby the seller promised a stream of payments for a period of time (or life) and the buyer agreed to make an up-front payment. Sellers, of course, were interested in making a profit, and buyers were looking for a level of long-term financial security. Sellers wanted to have a way to estimate how much money they would have to pay, so they developed early versions of actuarial tables to measure and predict life expectancy. Annuities have gone through many revisions and iterations over the years, including French tontines, which provided lifetime payments in return for an up-front payment. This is similar to how a regular annuity functions, but with tontines, as one of the purchasers dies, the accounts were divided among the survivors. Today, annuities are developed and sold by insurers, who employ actuaries to do what actuaries have always done – determine life expectancy of one or more groups of people. The life expectancy tables are a major component of determining required funding and payment amounts to annuitants and beneficiaries. Early on, annuities were considered conservative options, especially as they offered income guarantees. Today, while some of that approach continues, annuities may be less conservative and offer several more options than those that existed previously. In today’s world, annuities are simply another investment option, one that, in some territories, provides tax benefits. However, annuities continue to offer, as one of their most valuable options, the possibility of a lifetime income stream. In a time value of money context, an annuity is a stream of payments. We can apply that concept to the annuity product. At its core, it was (and remains) designed to provide a stream of regular payments to the annuitant (i.e., the owner/beneficiary and recipient of the payments). An annuity’s function is to spread invested capital and earned interest over a period – such as the life of the annuitant. Actuaries and mortality calculations enter the picture to determine, based on age, and sometimes gender, the amount of each periodic payment to the annuitant. When the capital and interest turn into an income stream, the contract is said to be annuitized. Annuities do not have to be annuitized over the lifetime of the annuitant. Payments can be structured to last for a specified period, such as 10 or 20 years. In fact, many of today’s annuities do not have to CFP Level 2: Module 1 – Retirement Planning Page 13

be annuitized at all. Unlike with their original iteration, annuity owners may simply make withdrawals at those times when they want to add some income to their cash flow. We should note that some jurisdictions, notably those offering tax-deferred earnings, might require that withdrawals, in specified amounts, begin by a certain age. Further, depending on the contract, either the insurer or the government may assess taxes, surrender charges and penalties against withdrawals. Let’s explore some details regarding annuity types, funding and pay out options. Types of Annuities Immediate Annuities Immediate annuities are those where a single sum is deposited and payments to the annuitant normally begin one benefit period after the contract is issued. The annuity payments are either a fixed amount (immediate fixed annuity) or an amount that varies with the unit value of the underlying fund (immediate variable annuity). An immediate annuity (annuitization) most often is purchased because the buyer wants to begin receiving a stream of regular periodic payments that are guaranteed by the insurer to last for some pre-specified period of time, generally the remaining life of the beneficiary(s) or some other pre-selected time frame. Two very important considerations exist when contemplating annuitization. First, annuitization is generally irrevocable. Once payment begins, no option exists to reverse the decision and retrieve the principal. The second consideration is the erosive long-term effect of inflation on purchasing power; inflation at four per cent per year halves purchasing power in a mere 18 years. This substantial risk cannot be ignored by the advisor; clients should always be alerted to this risk and presented with the option of inflation-adjusted payments. Deferred Annuities Deferred annuities allow for payment of either a single sum (single-premium deferred annuities) or a series of payments over a period of years (fixed or flexible-premium deferred annuities). The accumulation period begins once the first premium payment is received and the contract is issued. This period lasts until the time when the funds are removed from the contract under an annuity option. The policy owner normally has the option of making occasional withdrawals, receiving periodic (i.e., annuity) payments under one of several possible annuity options, or taking a lump-sum cash payment. Annuity payments begin at the date stated in the contract, although generally the annuity start date can be changed by the policy owner at any time before annuity payments begin. The amount of the payments depends on several variables, including the amount invested, the return earned on that CFP Level 2: Module 1 – Retirement Planning Page 14

amount, the age of the annuitant when payments begin, and the period for which payments are guaranteed. Payments consist of both principal and interest. Annuity payments can be based on the life of one person or on the lives of two or more people. An annuity contract issued on two lives, where payments continue in whole or in part until the second person dies, is called a joint and last survivor annuity. An annuity issued on more than one life, under which payments stop upon the death of the first person, is called a joint life annuity. While withdrawals may be permitted if funds are needed prior to annuitization, they may be subject to tax or other penalties (depending on the company and jurisdiction). The issuing insurance company may impose penalties (called surrender charges) on annuity distributions. Surrender charges normally do not last throughout the entire contract period. Instead, they normally decrease over a period of years until they are eliminated. After the first year, investors often can withdraw a percentage of the annuity’s value without incurring a surrender charge. Because of possible penalties and tax considerations, individuals should consider whether an annuity is the best option for their money and their goals. Once the annuitant selects an annuity income option and payments begin, the annuity account is more or less frozen. At this point the owner has used the amount accumulated in the annuity to purchase an annuity payment stream from the insurance company—so any amount previously accumulated in the annuity no longer belongs to the owner (it was “sold” to the insurance company for the income stream). When someone says the funds in an annuity are “annuitized,” he or she is referring to this purchase. Some companies are making changes to annuities that allow for increased distribution (pay out) flexibility. Fixed Annuities Annuities may be fixed or variable, and the two options are quite different. In the same way that a whole life insurance contract is fixed, meaning pre-set premiums, cash values and death benefit, a fixed annuity contract is pre-set. A fixed annuity payment period may be immediate or deferred, but either way, the amount is fixed in the contract. Contracts almost always vary by company, so even though we can identify basic or core contract types and benefits, it is highly likely that individual insurers will offer variations. Also, we are talking about base contracts. Insurance contracts and annuities often provide options (i.e., riders, endorsements or additional features) that modify basic coverage. As an example, we may identify that a basic fixed annuity contract provides for level payments throughout the contract period. However, the annuity may also have an option that provides for inflation (e.g., cost-of-living) adjustments. These additional coverage options and guarantees almost always increase a contract’s expenses. As such, you should do a cost-benefit analysis to determine which options, if any, you should recommend. CFP Level 2: Module 1 – Retirement Planning Page 15

Fixed annuities are generally more appropriate for conservative individuals, and those who want a guarantee of future income. Deposits are invested in the company’s general account and provide a low, guaranteed return. The return paid on a fixed annuity is a potential downside. Remember the basic investing rule: low risk usually results in low returns. This holds true for annuities. In fact, if an advisor sees a fixed annuity offering overly high returns or pay outs, he or she should be suspicious and investigate how the high returns are being generated. Chances are good that the insurer is using hedging techniques (not always a bad thing) or increasing risk levels in some way that may not be appropriate for a client. Peace of mind is the biggest value of fixed annuities for many individuals. Some people are willing to forego higher returns and higher income payments in favour of a guarantee. However, others are not so willing, and for them, a variable contract may be appropriate. A deferred fixed annuity is a savings account that earns a fixed rate of interest for a time specified by the insurer. After that period, the insurer establishes a new rate. A bailout provision is an annuity contract provision in which the company agrees that if any new rate established by the company is below the rate specified in the provision, money in the contract can be withdrawn without a company- imposed penalty. Not all contracts offer a bailout provision. The insurance company typically guarantees both principal and interest in a fixed annuity. Assets backing fixed annuities stay in the company’s general account and are subject to creditors’ claims in the event of insurer financial difficulty. Variable Annuities One big problem with fixed annuity payments is that they are fixed. The guaranteed pay out amounts is a two-edged sword. On the one hand, the annuitant can feel secure (assuming on going insurer financial viability) in knowing exactly how much money will be coming in each month. That very security, however, often creates problems. A fixed payment never changes, but cost of living almost always does. As previously discussed, market risk is not the only type to note. Especially for those who live long, maintaining purchasing power can be a risk that is as big, or bigger. With any amount of inflation, the cost of an item tomorrow will almost certainly be greater than today’s cost. The same is true for all inflation-sensitive expenses, and if all the annuitant’s payments are fixed, eventually he or she may begin to struggle financially. A variable annuity may provide a solution, in that, depending on investment returns, annuity payments may keep pace with inflation. If we can compare a fixed annuity to a whole life insurance policy (minus the life insurance part), we can compare a variable annuity to a variable (or VUL) life contract. The variable annuity accumulation account invests in owner-chosen mutual funds, or their insurer equivalent. This means that variable annuities are securities, and must be treated as such (including observing all licensing-related requirements). CFP Level 2: Module 1 – Retirement Planning Page 16

All annuities, other than those with immediate annuitization, have two primary periods. During the accumulation phase, the owner makes deposits into the annuity (or one deposit, with a single- premium annuity). In a fixed annuity, these deposits go into the general fund and earn whatever rate has been contractually guaranteed (plus any excess, if applicable). This is not what happens with a variable annuity. Variable annuity deposits purchase accumulation units, and are invested in whatever fund or funds the client (annuity owner) has selected. For example, assume the cost of an accumulation unit is $100 and the owner deposits $100. He or she would have purchased one accumulation unit. If the deposit were $500, the client would have purchased five units. When the time comes to annuitize, the initial annuity payment amount would be determined based on the number of accumulation units in the contract. From that time on, as the value of each unit (now called an annuity or payment unit) increases or decreases, annuity payments would raise or lower in response (more on this later). The value of each accumulation unit varies, just as the value of each mutual fund share varies, based on market returns. Some annuities offer minimum earnings guarantees, but such guarantees always come at a price, which must be weighed against the benefit provided. As is the case with variable life insurance policies, some contracts offer just a few investment alternatives, while others may offer hundreds of options. Investment options have all the same type of expenses as with any mutual fund, including those related to investment management and distribution. Additionally, all annuities have expenses related to the actual annuity contract. These include administrative charges along with mortality-related expenses. Some contracts may have sales charges, and if so, they are usually of the contingent-deferred or surrender variety. That is, if the owner withdraws money from the contract within a set period following the original purchase (e.g., 10 years), the insurer may deduct a percentage from the withdrawal as a way of recapturing sales charges. Some contracts, but not all, allow minimum withdrawals without assessing a sales charge. Typically, surrender charges eventually fall away. A financial advisor should be aware of the period and amount of any surrender charges and advise accordingly. Most contracts allow the owner to move money from one investment option to another, but the number of times this can be done annually may be limited, and fees sometimes accompany the transfers. If you are getting the idea that at least some variable annuity contracts can have a lot of fees, you are correct. While annuities, like most investment options, can serve a valuable function, advisors must exercise caution to determine whether related fees are appropriate or excessive. Also, when trying to calculate annuity investment returns, you may see a sizable difference between gross and net returns – especially in the contract’s early years. Focus on the client’s need, as is true with any investment option, to weigh benefits against expenses, and carefully consider whether to use or recommend annuities accordingly. CFP Level 2: Module 1 – Retirement Planning Page 17

The annuity phase or pay out period follows sometime after the accumulation phase. In the case of fixed annuities, payments will be fixed and clearly identified at the beginning of the pay-out period (remember that some contracts offer inflation adjustments). Variable annuity payments are not fixed, and only the initial payment will be identified. We should mention that it’s always possible that the client will want to liquidate the contract and receive all available funds in a lump sum. This pay out may or may not be taxable (at least in part), depending on regulations in the jurisdiction, and the type of contract. Assuming the client elects to have a payment stream, the insurer would convert accumulation units to annuity or payment units. All the same distribution options apply to variable contracts as are available with fixed annuities (e.g., single life, joint life, period certain, etc.). The client often has the option to opt for a fixed pay out or one that is variable. Sometimes, both options can be applied to part of the contract’s value. Since the variable pay out option is a big part of the rationale for variable annuities, most people choose this path. The payment amount of each annuity unit reflects the annuitant’s age, and sometimes gender, life expectancy (just as with fixed annuities), pay out option (e.g., single life, period certain, etc.), and investment return. That last item is what causes each payment to vary. Sometimes payments are guaranteed for a period, but if not, each payment will rise or fall as the value of the underlying investments does the same. For this reason, annuitants cannot accurately predict the amount of each payment they would receive. At the same time, assuming solid investment performance, the annuitant should be able to count on at least the potential that payments would keep up with inflation. Remember, the number of annuity units does not change, but their value does. This may be re-calculated on a monthly, quarterly, semi-annual or (often) annual basis. Indexed Annuities Indexed annuities (IAs) offer some of the growth potential of the stock market with the downside protection of a guaranteed annuity. These products are fairly sophisticated, so both financial advisors and their clients should have a firm understanding of these annuities before adding them to a portfolio. Further, there are several variables in these products, which can make comparisons difficult. Many regulators have issued warnings expressing concern over the complexity of and potential problems associated with IAs. Indexed annuities have characteristics of both fixed and variable annuities. They usually provide a guaranteed minimum interest rate and an interest rate tied to a market index. They typically are linked to a benchmark (such as the S&P 500), which provides the growth potential in these accounts. The participation rate determines how much of the underlying index’s gain will be applied to the account value. For example, if the participation rate is 90 per cent, and the S&P increases by 10 per cent in a period of time (called the index interval, which can be 1, 5, 7, or even 10 years), the annuity’s account value would increase by 9 per cent (90 per cent of the 10 per cent increase). Some annuities CFP Level 2: Module 1 – Retirement Planning Page 18

also may have a rate cap, which will limit the amount of growth that can be applied to the account value for a given interval. There are different methods of measuring the change in the underlying index. The percentage change method measures the percentage change in the index from the beginning to the end of the index interval. Only the index’s starting and ending points matter; market fluctuations in between are ignored. In those intervals when the index declines, no gain is credited to the account. The ratchet method (also called point to point) locks in the gain credited to the account each policy year. The index value at the end of one policy year becomes the starting value for the next policy year. The spread method subtracts a fixed percentage (such as two per cent or three per cent) from the index’s percentage change in a given interval. If the index grew by 30 per cent over a three-year interval and the insurance company used a two per cent spread, the account would be credited with a 28 per cent increase in value. In terms of downside protection, assume the S&P 500 declined 10 per cent over a given index interval. In this case, the annuity’s account value would remain unchanged from its starting point for that interval. While the annuity owner did not earn any interest or have any gain during this period, neither did the account lose money due to the market’s drop. This downside protection can be very appealing to a client who wants to participate in the market’s gains (to a limited degree) while avoiding market losses. The idea is that the account value in an indexed annuity will not decline unless the owner takes a withdrawal. The timing of a withdrawal can have a significant impact on the participation rate. The ideal situation would be for the annuity owner to only take withdrawals immediately after the participation rate (for a given interval) has been credited to the account. Once the participation rate has been credited to the account, the increase in account value is locked in and guaranteed into the next index interval. So, you can see that a withdrawal in the middle of a participation rate interval could minimize the growth potential of the account for that period of time. One final note: as mentioned above, regulators are giving IAs extra scrutiny. They are concerned that these products may be too complex, that IAs are not being adequately described (with adequate disclosures) to potential clients, and that there is too much opportunity for abuse. Settlement and Pay out Options Annuity payment options are essentially the same as life insurance settlement options. In both cases, lump sum payment is the option most commonly used. This gives the beneficiary all the funds at once. These can be used then for any purposes and serve a valuable cash flow function. When beneficiaries choose to receive regular payments in lieu of a lump sum, the life income option is most frequently chosen. This option will make payments during the life of the beneficiary. At death, all payments stop, CFP Level 2: Module 1 – Retirement Planning Page 19

regardless of whether money remains in the account or not. As an example, assume an account has $100,000 and the beneficiary has chosen a life income (or single life) payment option. If the beneficiary dies after receiving payments of $20,000, the remaining $80,000 will stay with the insurer. There is no recourse. This is why this option is seldom recommended, except possibly for situations in which only one individual is involved, and he or she does not wish to leave a bequest to anyone. In addition to life income, annuities also offer other options: Joint (and survivor) – payments continue during the lifetimes of both annuitants, after which they terminate. Joint payments may remain level during both lifetimes, or may be reduced (e.g., one-half) following the death of the primary annuitant. If the annuity has a survivor option (certain jurisdictions only) any amount of the basis (i.e., capital plus earnings) that remains after the deaths of the annuitants will be paid to a beneficiary. Period certain – annuity payments continue for at least a minimum number of years (e.g., 10). Depending on the contract terms, payments may end once the set number of years has passed, or may continue for the remaining lifetime of the annuitant. If the annuitant predeceases the period certain, remaining funds go to a beneficiary. Fixed amount – annuity payments made in a fixed amount (e.g., 1,000 pesos) for as long as the principal (and earnings) last, after which all payments stop. Refund – depending on the pay out option chosen, the contract may allow for a refund of any remaining money (principal plus earnings) left in the contract at the end of the annuity period (i.e., when the annuitant dies). Where included, the total of payments will be calculated, and if less than the total amount of principal and earnings in the contract, the remainder will be paid to a beneficiary. As an example, if the principal is $100,000, and total payments add up to $80,000, the beneficiary will receive the remainder of $20,000. However, if total payments are more than $100,000 (in this example), the beneficiary will receive nothing, as the original principal has been fully distributed. Some contracts may allow for variations on the primary options listed above. Further, it may be possible to allocate some of the capital to more than one pay out option. Finally, the preceding annuity option list refers to annuitization, not periodic withdrawals. Withdrawals, where allowed, enable the owner to receive money from the contract without changing the contract’s structure, and keep annuitization options open. It’s easy to see why annuities have a long history as part of many retirement planning packages. It should also be fairly easy to understand why, at least with some applications, financial advisors and their clients should exercise a degree of caution when implementing this option. This may be more or less true in various territories depending on potential penalties, regulatory limits, and tax implications. In this chapter we explored some of the retirement benefits provided by governments and employers, along with ways in which annuities may be used to fund retirement cash flow. The ultimate purpose of CFP Level 2: Module 1 – Retirement Planning Page 20

retirement planning is to produce enough assets and cash flow to support desired lifestyles and goal achievement. This brings us to retirement cash flow and withdrawals strategies. We will explore this area in the next chapter. Question Annuities have been used as part of retirement funding for many years. They are an investment option rather than a retirement plan type. Which of the following statements regarding life annuities is least likely correct? a In most cases, if you buy a life annuity for $100,000 at age 65 with an income of $500 per month, your family will get $10,000 back if you die at 80 years old after 180 payments. b If you buy a life annuity for $100,000 at age 65 with an income of $500 per month, you get your $100,000 back by age 82. If you live past 82, you will still receive $500 a month as long as you live. c With a life annuity there is no risk of outliving your income. d A life annuity provides guaranteed income payments for as long as you live Correct Answer A Explanation In most cases, your life annuity income payments stop when you die and no money goes to your estate or a named beneficiary unless there is a joint and survivor option, a guarantee option or a cash-back option. Distractor #1 b If you buy a life annuity for $100,000 at age 65 with an income of $500 per month, you get your $100,000 back by age 82. If you live past 82, you will still receive $500 a month as long as you live. Distractor #2 c With a life annuity there is no risk of outliving your income. Distractor #3 d A life annuity provides guaranteed income payments for as long as you live CFP Level 2: Module 1 – Retirement Planning Page 21