With the first wave of boomers starting to spend down that nest egg, one recent academic study suggests the government should create incentives for boomers to spend it as carefully as they saved it—by offering tax-breaks and/or credits on income from annuities. Besides helping retirees stretch their assets to last throughout retirement, it could improve competition and pricing in the annuity industry, and could even boost gross domestic product, the study contends.
“It’s absolutely essential to make [annuities] a component of people’s retirement landscapes,” says Casey Rothschild, an economics professor at Middlebury College and co-author of the study. “Especially with the uncertainty surrounding defined-benefit plans, there’s a major risk that people will run out of money,” he says.
Called Lifetime Annuities for US: Evaluating the Efficacy of Policy Interventions in Life Annuity Markets, the study was published in late October by the American Council for Capital Formulation, a nonpartisan, nonprofit think tank in Washington, D.C. Written by Rothschild and William Gentry, a professor at Williams College (click here to download the full report), it makes the case for legislating tax breaks and/or credits for income from annuitized assets.
“We’re talking specifically about an immediate life annuity or lifetime annuity,” says Gentry. “In other words, a basic pension-replacement device.” As opposed to the much more heavily marketed “deferred annuity,” which is designed to accumulate savings because any growth in the account is not taxed until gains are withdrawn. Deferred annuities, specifically variable annuities, have been a target of SEC and NASD investigations in recent years. (Other types of deferred annuities include fixed and equity indexed: To learn more about these annuities, click here).
The study examined a June 2005 legislative proposal by Representative Earl Pomeroy (D-N.D.), called the Lifetime Pension Annuity for You Act of 2005. The bill, H.R. 2951—which has been sitting in the House Ways and Means Committee since June but may see daylight in the next session—proposed exempting 25 percent or 50 percent of annuity income (depending on the source of the funds) from taxation, up to $5,000 for individuals or $10,000 for couples.
If the economists’ calculations are correct, the legislation could have widespread benefits. Among their findings: the tax break would serve to reduce the total cost of purchasing an annuity by as much as 8 percent; annuitization levels would rise by an estimated average of roughly $50,000 per retired household; and the cost to the government in lost revenue “would be a modest 10 cents to 15 cents per dollar.” (Not only that, but a separate study of the projected macroeconomic effects of the legislation—had it been in effect from 1995 to 2005—were equally impressive: boosting GDP by $34 billion per year; reducing unemployment by 0.1 percent; and increasing consumer spending by $36 billion per year.)
So how will high prices, a chief complaint from critics of the annuity industry, be brought down by a tax break? The costs of annuities are high, say the authors, partly because the types of people buying them are the ones that are the most costly for the insurance companies to insure—the healthy people who will live long. This is called “adverse selection.” By reducing the cost of purchasing an annuity, a tax break makes an annuity attractive to more people of average health. “Bringing them into the market lowers the insurance company’s projected costs, thus increasing payments to annuitants,” says Rothschild.
As it stands now, the public’s appetite for immediate annuities is not high: Of the $212 billion in annuity sales last year, only $12 billion (5 percent) came from immediate annuities. The vast majority of annuity sales are of the deferred variety, specifically variable annuities. In the first quarter of 2006 alone, total sales of variable annuities were $38.1 billion, a 20.5 percent increase from last year.
However, according to Cerulli Associates senior analyst Lisa Plotnick, most people don’t actually use the annuitization feature of their annuities. In fact, only 1 percent of investors in deferred annuities actually elect to annuitize the assets in the account when the target date arrives. “Most of them are using it as any other account, taking periodic withdrawals or a lump sum before the target date,” she says, defeating the product’s most marketed advantage—tax-free growth until eligible withdrawal.
Not surprisingly, Tom Mullen, vice president of annuity product marketing for John Hancock, is in favor of the legislation. Mullen says it would be a good thing if retirees learned the importance of annuitization. He says some of the aversion to immediate life annuities is that a lot of people simply have trouble giving over all or a chunk of their money to the insurance company without being able to get their hands on it if they need it. He says most of the top 20 firms selling annuities now offer guaranteed “withdrawal benefits” in certain products for those who want liquidity.
Another obstacle to annuitization, says Gentry, is the fact that most 401(k) plans don’t offer annuitization. His plan provider, TIAA-CREF, is one of the exceptions. “I was shocked to learn when I started researching this that most plans don’t offer the option to annuitize,” says Gentry. “You have to take a lump sum, roll it over and then find an insurance company—that’s a big paperwork obstacle the 401(k) industry should look at,” he says.
Eric Park, president of Steamboat Financial Group, an affiliate of LPL in Washington, Mo., says he likes the idea of a tax break on annuitized retirement assets. He also says the annuity market, in general, is improving. The concept of equity-indexed annuities is great, he says, and while prices are still too high, they are coming down. “Five years ago it was 7 percent or 8 percent, now it’s 2 percent to 5 percent for many fixed and variables.” And, says Park, there are also no-load offerings from places like Vanguard, Fidelity and TIAA-CREF. Ron Rhoades, a financial planner with Joseph Capital Management, says he likes the free annuity calculator Vanguard offers. (Go to “Vanguard Lifetime Income Program,” then “Get an Instant Quote.”)
Whatever your client’s portfolio looks like, figuring out how to provide an income stream is crucial nowadays because of life expectancies, says Park. “If you have a client couple that are 65 years old, there’s a 15 percent to 20 percent chance that one of them is going to live to age 92—that’s nearly 30 years of retirement income.”