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Sorting Out the Details on Contingent Deferred Annuities

There are not yet final answers to all of the questions surrounding these products, but we are beginning to see light at the end of the tunnel.

Judith A. Hasenauer, 12/02/2011

One of the hot topics in the financial-services industry is the "contingent deferred annuity." This relatively new product represents a change in direction for what is commonly believed to be the oldest form of life insurance. Simply viewed, the contingent deferred annuity is a group contract, usually issued in connection with an employer-sponsored retirement plan, where the insurer does not hold the assets underlying the annuity. It is somewhat akin to a term insurance approach to retirement planning where the participant under the group annuity maintains her investment in the assets held under the retirement plan while enjoying insurance protection against outliving the funds available for retirement.

The first attempt to create such a product came in the early 1980s, when a similar approach was taken to provide longevity planning for no-load mutual funds that were used for retirement plans. The concept was developed to enable such no-load mutual funds to stop the rampant switching of such funds where there was no penalty for early withdrawals. The trade association for no-load mutual funds contemplated sponsoring such a product for its members to stop the "hot money" syndrome that plagued the industry at that time. The product never got off the ground because the fund sponsors were unwilling to find a way to cover the costs for the product.

The past quarter century has seen the primary focus for the purchase of annuities--both variable and fixed--toward the tax-deferral inherent in deferred annuities. The creation of contingent deferred annuities has much of its origins in the attempt by banks and mutual fund managers to provide tax deferral to their savings products without having to lose the funds to insurance companies.

Contingent deferred annuities are relatively simple in their application. The insurer issues a group annuity contract that covers all of the participants in a retirement plan. The insurer makes a charge for the longevity protection and for any ancillary benefits that may be included in the product. Annuity payments are handled pretty much in the same manner as with traditional variable annuities. Net cash available from the retirement plan is used to make annuity payments, and cash flow planning is much the same as it is with more traditional products. Some products include a variety of living benefits, such as GMWB features that guarantee minimum annuity payments regardless of the performance of the investments underlying the retirement plans. An insurer can also make additional benefits available so long as the retirement plan sponsor or the plan participants are willing to bear the cost of such benefits.

Each participant under a contingent deferred annuity plan receives a certificate that indicates coverage and that outlines the terms and conditions applicable to the program. Although the primary intent behind the contingent deferred annuity is to provide longevity protection, minimum payment guarantees can also provide economic protection against adverse market conditions. This can provide a great degree of comfort to retirees in these days of volatile markets and ever-increasing longevity.

Regulators and taxing authorities, as well as insurers, have been wrestling with the nature of this new product. Is it a form of life insurance or casualty coverage? Are annuity payments taxed as such or will they be taxed in some other way? Are the products subject to SEC regulation and sales subject to FINRA supervision, or is it strictly an insurance product?

There are not yet final answers to all of these questions, but we are beginning to see light at the end of the tunnel. The IRS has issued a number of private letter rulings that seem to give the green light to the tax treatment of payments made to retirees under contingent deferred annuities. They will be treated as "annuity payments" in accordance with Section 72 of the Internal Revenue Code. This result should prevail whether the contingent deferred annuity is used in connection with a qualified retirement plan or with some other form of investment account, such as an individual mutual fund or a family of mutual funds.

The National Association of Insurance Commissioners has formed a group to study contingent deferred annuities in order to establish a uniform state regulatory program for the product. There is not, as yet, a clear indication of how many states will cover the guarantees included in contingent deferred annuities under state guarantee fund protection and which product features that such protection, if any, will cover.

Judith A. Hasenauer, JD, CLU, is an attorney with the law firm of Blazzard & Hasenauer, P.C. She devotes her practice exclusively to the financial services industry, providing consulting on the development and regulatory clearance of products, compliance issues, distribution issues and related matters, such as advisory activities and industry initiatives.

The author is not an employee of Morningstar, Inc. The views expressed in this article are the author's. They do not necessarily reflect the views of Morningstar.

The author is a freelance contributor to MorningstarAdvisor.com. The views expressed in this article may or may not reflect the views of Morningstar.

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