While annuities have always provided certain benefits, like tax deferral and death benefit protection, recent product innovations have created an enormous demand for annuities in retirement planning. As such, annuities are uniquely suited to address the concerns that come with retirement planning, including longevity, inflation risk, market volatility and uncertainty. We’ll be discussing variable annuities, the various riders and how exposure to equity investments coupled with income and death benefit guarantees are helping to provide today’s retirees with a reliable stream of income.
Retirement planning has changed. Up until recently, a client looked forward to retirement, believing that his financial future was secure; that after retirement, he would be entitled to a steady, predictable stream of income for the rest of his life. This rosy scenario was the norm for many retirees who could count on a tag-team of payments from Social Security and a company pension plan. These days, however, the future isn’t as bright for many individuals heading towards retirement.
A combination of the baby boomer generation reaching retirement, the recent economic downturn and the underfunding of the Social Security trust has resulted in an uncertain future for Social Security. Especially in light of the exploding deficit and heightened concern in Congress about this, there’s a real need to consider Social Security reform options, potentially resulting in reduced benefits for future generations.
Similarly, over the past decade, there’s been a severe change in employer-sponsored pension plans. The Pension Benefit Guaranty Corporation (PGBC) reported that there are only 38,000 plans in existence in 2010, compared to 114,000 in 1985.1 While the PGBC continues to insure over 44 million participants, many more plans have been frozen as a result of the economic downturn.
For these reasons, reliable sources of income in retirement are crucial, now more than ever. The desire for a steady guaranteed stream of income in retirement could be the reason annuity sales have been exploding over the past few years. In fact, according to its fourth quarter 2011 U.S. Individual Annuities Sales Survey, LIMRA, an association of insurance and financial services companies, reported that annuity sales increased 8 percent in 2011, reaching $240.3 billion.
Annuities are tax-deferred investment vehicles packaged in an insurance wrapper. That wrapper provides the various income and death benefit guarantees that set annuities apart from other types of retirement investments. Individuals make one or several purchase payments, and the insurance company promises to pay out an immediate or future stream of income.
There are three types of annuities: fixed, indexed and variable. All three variations provide tax deferral, guaranteed lifetime income and a return of premium death benefit guarantee.
Fixed annuities. The investor makes a lump sum payment or a series of payments to the contract and receives a guaranteed return of premium, a minimum interest rate and additional interest, as declared by the insurance company. The investor can also convert the fixed annuity into a stream of income immediately or at some time in the future.
Indexed annuities. This is a type of fixed annuity that’s linked to a specific equity or other index. Like a fixed annuity, a fixed index annuity provides a guaranteed minimum interest rate. However, a fixed index annuity also provides enhanced upside potential if the linked index outperforms the minimum guarantee. Although the annuity is linked to a specific index, the investor doesn’t directly own shares in that index, and, even if the index performs well, the interest may be capped.
Variable annuities. These are annuity contracts funded with sub-accounts, which are similar to mutual funds that fluctuate with market volatility. Because they may be invested in the market and, thereby, provide the owner with the corresponding risk or reward, variable annuities are typically used by investors who have a higher tolerance for risk, are looking for higher rates of return and have longer investment time horizons.
With a variable annuity, the investor makes a lump sum investment or series of payments and can allocate them among the various sub-accounts based on their investment objectives and risk tolerance. Because of the variable nature of the investments, however, the income stream can also fluctuate. Many insurance companies offer additional riders that can be used to protect or grow the income generated from the variable annuity.
Variable Annuity Innovation
Throughout the bull markets of the 80s and 90s, annuities were shunned, as advisors saw little value in downside protection for beneficiaries or the need to exchange a lump sum of cash for a guaranteed stream of income for life. When the tech bubble burst in 2000, many perceptions changed. As investors saw their investment and retirement portfolios drastically reduced, they began to seek out products that not only provided flexibility and protection from market turbulence, but also allowed a consistent stream of income with an upside.
As a result, annuity companies responded by creating products with innovative features that offered investors the security and flexibility they desired. They offered guaranteed withdrawal benefits (GWB) riders that could be purchased along with a variable annuity contract, which would preserve and lock in market growth and provide a steady stream of income for the client. By the time the recession hit in 2008, investors who had the foresight to invest in variable annuities with these special features were sleeping better than most: They knew that no matter what happened in the market, their retirement income was guaranteed.2
The new riders provide important retirement planning features for investors. First, during the accumulation phase, these riders allow investors to capture market upsides, or lock-in a guaranteed minimum percentage growth of the benefit value, which they can use to generate lifetime income.
During the distribution phase, the riders provide a guaranteed floor of income, while offering upside potential based on the performance of the sub-accounts. The stream of income that’s paid out is based on the guaranteed benefit value, which could continue to grow, but never decline. The client maintains an account balance that reflects investment performance and periodic withdrawals and, if his personal circumstances change in the future, he can terminate the contract and keep the remaining account value.
Let’s look at an example of how a GWB rider works. Assume that a client invests $100,000 into a variable annuity and allocates the $100,000 across a diversified portfolio of sub-accounts that includes stocks and bonds. The variable annuity GWB rider offers two guarantees: the first applies during the accumulation phase, and the second applies during the distribution phase. To illustrate how these guarantees work, it’s is also important to note that the client will have two values going forward: an account value and a benefit value. The account value is essentially the cash value of the contract, which can be withdrawn at any time (surrender charges may apply). The benefit value is used to determine the amount of lifetime income the contract guarantees.
During the accumulation phase, the rider guarantees that, as long as the client doesn’t take any withdrawals, the benefit value will increase by the greater of a certain percentage, like 5 percent in this example, or the current account value. For example, after Year 1, if the account value remains at $100,000, the benefit value will increase by 5 percent to $105,000. On the other hand, if the account value increases to $110,000, the benefit value will also increase to $110,000. This modification to the benefit base may continue each year, as long as the client doesn’t take withdrawals.
The benefit to the client is that each time he gets a step-up in the benefit base, that value locks in. Therefore, if we assume that the account value and benefit base both increased after Year 1 to $110,000, but the following year the account value dropped back to $100,000, the $110,000 benefit base wouldn’t only be locked in, but also the client would be guaranteed a 5 percent increase in the second year. This would raise the benefit base to $115,500, even though the account value or cash value of the contract retreated back to $100,000. Next, if we assume in Year 3 that the client would like to begin drawing income from the variable annuity, and the rider provided for a 5 percent guaranteed lifetime income, the benefit value would be used in determining the dollar amount of the annual income paid to the client. In our example, 5 percent of $115,500 would create an annual payment of $5,775. That payment would be guaranteed for life, but also would have the potential to increase. So, if the account value in Year 3 grows to $120,000, the client would receive a step-up in the benefit value from $115,000 to $120,000 and would then be entitled to 5 percent, or $6,000, a year for life from that point forward.
The beneficial account and income guarantees, as well as flexibility, illustrate why annuities have become popular among advisors and investors. No other investment provides these types of guarantees that are so vital to retirement planning.
Although annuities have grown in popularity, they continue to be criticized. Opponents cite lack of liquidity, expense and tax treatment as reasons why clients shouldn’t consider annuities. However, much of the negativity surrounding annuities is due to lack of understanding of the product. Annuities are meant to be long-term retirement investments that offer protection and benefits to investors that other investments don’t. It’s useful, then, to address these misconceptions, since many advisors are still missing opportunities to present annuities as retirement planning solutions.
Lack of liquidity. One often-noted downside to annuities is the perceived lack of liquidity. Since annuity contracts are meant to be invested for retirement planning purposes and offer tax-deferred growth and protection similar to that enjoyed by qualified plans, they’re designed for long-term investment objectives. Individuals seeking liquidity should probably choose an alternative investment vehicle. As with qualified plans, annuity investors may be subject to a 10 percent withdrawal penalty if they wish to access the annuity contract prior to age 59½ (although certain exceptions under Internal Revenue Code Section 72(t) and (q) may apply).
However, if a client must access a portion of the annuity, most annuity contracts include a liquidity provision that allows 10 percent of the original purchase payment to be withdrawn without penalty. And, while the insurance company may impose penalties should an investor wish to withdraw all or a portion of his contract before a certain time, the investor may purchase liquidity riders or choose a contract with a surrender schedule that typically ranges from zero years to seven years, in case he wants emergency access to his account.
Expense. Opponents also cite expense as another drawback to annuities. Many advisors unfairly compare the perceived high cost of annuities to alleged low-cost mutual funds, which isn’t a true apples-to-apples comparison. Annuities provide protections that mutual funds don’t; the extra expense for an annuity goes to the insurance wrapper that provides equity exposure with downside protection (in the form of a guaranteed death benefit) and guaranteed lifetime income regardless of market performance. While a particular mutual fund may boast lower fees, it can’t provide the peace of mind and protection against market volatility that annuities do. Many investors have been more than happy to pay a little extra for those protections over the past few years.
In addition, investors point out that variable annuities can be loaded with fees, especially as they attach additional living and death benefit riders to the contract. However, many new annuity contracts allow clients to purchase the features and benefits à la carte. Therefore, an investor may balance his needs with cost and purchase only the riders that he desires.
Tax treatment. While annuities are tax-deferred vehicles during the accumulation phase, distributions from an annuity are taxable at ordinary income rates. For immediate annuities, the distributions are taxed according to an exclusion ratio; that is, each distribution is part basis and part growth, and, therefore, only the growth portion is taxable at ordinary income rates. For deferred annuities, distributions come out as last in-first out, so, to the extent that there are gains in the contract, those gains would be distributed first (and taxable) followed by return of principal.
This brings up another common misconception; that, unlike a mutual fund that would likely be taxed at the capital gains rate, distributions from a variable annuity are taxed at the ordinary income rate. Most opponents point to the top tax rate of 35 percent when comparing annuity and mutual fund withdrawals, but the reality is that, due to our progressive tax system, few people pay taxes on ordinary income of 35 percent. Only ordinary income in excess of $388,350 is taxed at 35 percent, and all income earned below that is taxed at a tiered rate. For most individuals, their effective tax rate is less than 20 percent, and the majority may be close to 15 percent or less.
Once used primarily for death benefit and tax-deferral benefits, annuities are now regarded as flexible investments that combine the inflation hedge of equities with downside insurance protection to provide a reliable stream of income in retirement. Advisors and clients who understand their unique value use annuities not only as straightforward retirement investments, but also position them as funding vehicles in traditional and Roth IRAs as solutions for retirement, estate and tax planning and as alternative investments for clients who are risk averse, but need exposure to the equity markets.
Retirement planning. With the recent market downturn drastically reducing many 401(k) plan balances and general uncertainty for the long-term, annuities have become increasingly popular. Many advisors now recommend them as another form of pension plan—one that would allow the investor to receive a guaranteed stream of income for life, regardless of market performance and longevity. To reinforce the need for a guaranteed stream of income in retirement, in January 2010, President Obama announced his support for annuities and other forms of guaranteed income as retirement vehicles.3 Recently, the Treasury Department and the Internal Revenue Service released two proposals that would encourage individuals to choose partial annuities instead of a lump sum payment from their pension plans4 and invest in longevity insurance that would provide coverage in the event a retiree outlives his required minimum distributions (RMDs).
In addition, as the recession and sluggish recovery, as well as longevity concerns have caused advisors and clients at or near retirement to be concerned about running out of money, many have been forced to take a second look at sustainable withdrawal rates. Just a few years ago, a 5 percent or 6 percent lifetime withdrawal rate was thought to be sustainable. But, with the loss of retirement income due to market fluctuations, experts are reducing withdrawal rates to preserve and stretch retirement accounts.
One concern is that as clients age, their RMD rates increase and, if clients withdraw their RMD and spend it, over time, their accounts could be depleted sooner than expected. Most of the new annuity income riders are RMD friendly, so not only do they guarantee a set percentage for life, say 5 percent, but also, if the RMD exceeds the guaranteed annual withdrawal amount, the annuity company will pay out the higher amount and still guarantee lifetime income. The implications for income maximization and aggregation of RMDs between an RMD friendly annuity and other assets held outside the annuity create some unique planning opportunities.
Funding IRAs or Roth IRAs. The new withdrawal benefits also create planning opportunities for clients with traditional and Roth IRAs. An IRA funded with a variable annuity and GWB can provide a steady stream of income for an investor in retirement, similar to a pension plan. During the accumulation phase, the account value fluctuates with the market, while the benefit base locks in market gains or grows by a certain percentage periodically. When the client begins taking distribution, he’s guaranteed a stream of income from the greater of the two accounts for life.
Since IRAs already enjoy tax-deferred status, many advisors previously believed that funding an IRA with a tax-deferred vehicle, such as an annuity, would be redundant and unnecessarily costly. Over the past decade, however, the industry has become more regulated, suitability standards more defined and both the advisor and client more educated on annuities.5 As products became more innovative, more clients saw the value in funding their IRAs with annuities. In National Association of Securities Dealers Notice 99-35, the regulators discussed the various applications of annuities, including using them to fund tax-qualified plans, such as IRAs. The notice pointed out the instances when recommending an annuity to fund an IRA would be suitable, stating that in those cases, the advisor “should recommend an annuity only when its other benefits, such as lifetime income payments, family protection through the death benefit, and guaranteed fees, support the recommendation.”
Likewise, because of its tax-free status, there’s even more incentive to fund a Roth IRA with a variable annuity and GWB rider. The owner may receive distributions from his benefit base that could, possibly, far exceed the actual account value—these distributions wouldn’t be taxable under Roth IRA rules for qualified distributions.
Legacy planning. Annuities offer many benefits in legacy planning. First, annuity contracts use beneficiary designations, which allow the assets to avoid probate and the need for trusts in some circumstances. Also, death benefit riders are often used to help enhance an investor’s legacy to his beneficiaries, and the extra step-ups can help pay for settling the estate, tax liabilities and other costs.
In addition, IRC Section 72 states the options that beneficiaries have to receive distributions upon the death of the owner or termination of the annuity contract. In most cases, when a surviving spouse is named co-owner or beneficiary, he may continue the contract and name new beneficiaries. Upon the death of all owners, the beneficiaries must either annuitize the contract or take the distribution in a lump sum or in payments over five years and pay ordinary income taxes on the gains. Alternatively, the beneficiary may take advantage of a provision of IRC Section 72(s), whereby a beneficiary may stretch his distributions over his lifetime by taking account of his age, life expectancy, account value and distributions. In this way, he may stretch out the taxability of the annuity across several years rather than take a lump sum payment and pay taxes on the entire amount, and the remaining balance could continue to be invested in the market, thereby potentially maximizing future distributions.
Many companies that offer the stretch provision also offer beneficiary distribution forms, often known as a “poor man’s trust,” which allow the owner to preselect the method by which each beneficiary will receive his death benefit. This allows an owner to let a responsible beneficiary choose his distribution payout and also limits a free-spirited beneficiary to a particular payout.
Tax planning. In today’s economic environment and with tax law changes looming (and taxes possibly going up), annuities could provide tax-efficient strategies for clients who want to defer income until retirement, while maximizing growth. If Congress fails to pass legislation extending the Bush tax cuts, taxes are expected to increase, beginning in January 2013. The top ordinary income tax rates will go from 35 percent to almost 40 percent; top capital gains tax rate from 15 percent to 20 percent; and dividends will be taxed at ordinary income tax rates. In addition, assuming President Obama’s health care bill is upheld, an additional 3.8 percent tax may apply to investment income for families who earn $250,000 or more, beginning in 2013.
Because annuities offer tax deferral, this advantage sets them apart from other investments subject to annual taxation. Clients may continue to benefit from tax deferral, even as the value of the contract increases; only when clients start drawing income from the contract would any tax be applicable. Similarly, the health care tax won’t be levied, even as the contract increases in value, until money is withdrawn from the annuity. This allows maximization of growth in the contract without threat of taxation during the accumulation phase.
Low risk investment for risk-averse investors. In addition, many investors heading into retirement feel somewhat burned by the recent market downturn and seek out strategies that are principal-protected and low risk. Advisors have found fixed and variable annuities to be the right strategy for many skittish investors. Fixed annuities tend to be lower cost and, for an older client, can provide an immediate or deferred stream of income at favorable rates with very little risk.
Variable annuities with GWB riders can encourage the risk-averse investor to stay in the market to gain the upside, while the GWB provides protection against downside risk and market uncertainty. In addition, these products also provide a buffer against inflation, since most riders lock in market gains periodically and may step up the contract. And, unlike other investments that stop paying out when the account reaches zero, these products protect against longevity by providing a consistent stream of income no matter how long the client lives.
A Second Look
While investors have found annuities to be a saving grace from the economic downturn, the competitive products, sluggish recovery and extended low interest rate environment have forced several companies out of the business. Over the past few years, long-standing stalwarts of insurance have exited or restricted their annuity distribution units for various reasons. Many companies offered extremely competitive products and benefits, but may not have been sufficiently hedged against the market downturn and the low interest rate environment to maintain the business. Insurance companies have bolstered their reserves and tweaked their products to continue to provide the benefits that appealed to clients during the recession and to weather any potential economic storm. While some product features have been reined in somewhat, the unique features of annuities will continue to appeal to investors searching for an effective retirement strategy.
The structures and features of annuities have changed considerably over the past decade, and many of the preconceived biases against annuities are out of date. In an economic and fiscal environment that’s resulted in a great deal of uncertainty with regard to sources of reliable retirement income, clients are seeking retirement income solutions that also offer peace of mind. As an advisor, you’ll serve your clients well to conduct the due diligence on all retirement planning options, including annuities, rather than have your client later ask the question, “Why didn’t you suggest using annuities?” If you haven’t recently considered annuities and the features they provide, it’s time to take a second look.
1. Steve White and Mark Olleman, “Rethinking the Pension Freeze,” Milliman White Paper (September 2010).
2. Leslie Scism, “Long Derided, This Investment Now Looks Wise,” The Wall Street Journal (July 24, 2009).
3. Ron Lieber, “The Unloved Annuity Gets A Big Hug From The President,” The Boston Globe (Jan. 31, 2010).
4. Private Letter Ruling 200951039 (Sept. 21, 2009).
5. Financial Industry Regulatory Authority Regulation 2821.