Executive Summary
For the past 40 years, variable annuities have been on a rollercoaster, where the popularity of various features and benefits rise and fall as the contracts shift and adapt to the then-current environment. In the early years, variable annuities were popular for tax-deferred investing as top tax rates of the time were 70%, and remained popular in subsequent years as the burgeoning bull market made equity investing more appealing overall, even as tax rates declined. As the 2000s approached, variable annuity companies innovated, creating a wave of so-called "living benefit" riders that included GMIBs and GMWBs, to make variable annuities appealing to the coming onslaught of baby boomer retirees. Unfortunately, though, with the financial crisis, living benefit riders became far less appealing - old contracts forced annuity companies to raise reserves, and new contracts experienced a significant cost increase as annuity companies struggled to hedge and manage risk in a more volatile post-crisis environment.
As a result, annuity companies are now entering a new wave of innovation - where variable annuities are bolstered by more innovate active management and alternative investment strategies, and the annuity itself is used as a tax shelter for these rather tax-inefficient investments, at a drastically lower cost than the annuities of recent years. Whether this new line of investment-only variable annuity (IOVA) contracts will catch on remains to be seen, but the potential is for variable annuities to become a major part of portfolio design in the future - where the variable annuity becomes an asset location tool and clients can voluntarily choose how much of their most tax-inefficient investments will be sheltered by tax deferral.
The Variable Annuities Of Decades Gone By
In the 1970s, non-qualified variable annuities were popular as a way to invest on a tax-deferred basis, typically with the intention of eventually annuitizing the funds as a supplement for (or alternative to) a traditional pension. In an era where the top tax rate was 70%, the potential to enjoy tax deferral on retirement accumulations until it was actually time to retire was incredibly appealing.
However, deferred variable annuities were of limited popularity in the 1970s, due to the difficult return environment for stocks. Some contracts provided a guarantee that ensured premiums paid into the contract would be returned at death, if the contract had experienced losses, but even with this insurance benefit, variable annuities were slow to gain popularity. Instead, fixed annuity contracts tended to be more popular, to the extent they could be invested at then-appealing interest rates.
As interest rates began to decline and the equity bull market got underway in the 1980s, variable annuities became more popular. However, their growth in popularity was limited, both by the fact that tax rates declined significantly with President Reagan's tax reforms (making tax deferral somewhat less appealing), and the growing popularity of IRAs and 401(k) plans that gave both tax deferral and a tax deduction upon contribution. As a result, variable annuities were generally only the domain of the most affluent individuals who were looking for a tax shelter for growth after maxxing out available retirement plans, although variable annuities had also begun to grow as an investment option within employer retirement plans, especially 403(b)s.
In the early 1990s, the marketplace for variable annuities grew steadily, driven heavily by the booming growth of the stock market, which increased public desire for equity investing and made the benefits of tax-deferred growth even more relevant.
Variable Annuity Companies Begin To Innovate
In the late 1990s, as the markets increasingly "just went up" the guaranteed return-of-premium death benefit of most variable annuities became less and less relevant or appealing. In addition, annuity companies began to experience some significant outflows (although they continued to grow as inflows exceeded withdrawals), as early annuity savers began to retire and liquidate their annuity contracts.
Accordingly (and in anticipation of the baby boomer retiree wave soon to come), in the late 1990s and into the 2000s, a new generation of innovative variable annuities began to emerge - contracts that were intended to provide not just guarantees at death, but also income guarantees during life, also known as "living benefit" riders. First came Guaranteed Minimum Income Benefit (GMIB) riders, followed a few years later by Guaranteed Minimum Withdrawal Benefit (GMWB) riders, all intended to make a variable annuity appealing and relevant for retirees as well as accumulators. Notably, the guarantees at death were often enhanced as well, with "high water mark" and guaranteed growth rate features that ensured the death benefit feature would remain relevant, even years after the original annuity purchase. Notwithstanding the fact that all of these guarantees could be rather expensive, they remained extremely popular; by the peak in 2007, many variable annuity companies were issuing more than 90%-95%+ of all their annuities with living benefit riders!
However, variable annuities and their living and death benefit guarantees hit a significant snag later in the decade: the financial crisis and 2008-2009 bear market. The problem was not simply that as a result of the market decline, many of the annuity contracts became "in the money" for policyowners as the guarantees became more valuable than the annuity cash value. It was that all the annuity contracts became in-the-money for policyowners at the same time, resulting in a dramatic increase in reserve requirements for annuity companies and a big hit to their earnings. In addition, pricing for the annuity contracts going forward became more problematic, as the rise in volatility in the years after the financial crisis made it far more expensive for annuity companies to hedge and manage their own risk. The end result - not only did annuity companies struggle with profits for several years due to the financial crisis and its impact on reserve requirements, but it simply became impossible to provide annuity guarantees on new contracts at a cost anywhere close to the earlier contracts.
A New Decade And A New Generation Of Investment-Only Variable Annuities (IOVA)
As we enter the new decade of the 2010s, variable annuities are taking a step towards a new frontier - in large part, by taking a page from the playbook of decades ago.
The new trend in variable annuities is once again to use them as a vehicle for tax-deferred investing, but in a far more targeted manner. While in the early years variable annuities were a general tax shelter against very high ordinary income, capital gains, and dividend tax rates, in today's environment the benefit is far more limited; the overall tax brackets are lower, and we provide significant tax breaks for long-term capital gains and qualified dividends (at least until/unless the fiscal cliff lapses). However, today's world - and especially the current economic environment - has opened up a new wave of investing vehicles, from managed futures funds to more active tactical asset allocation strategies, which share one important common characteristic: even with today's tax rates, they are very tax-inefficient investments.
Accordingly, many of the latest next generation investment-only variable annuity (IOVA) contracts have a particular focus in offering an array of alternative and active management strategies, where the tax-deferral wrapper of the annuity is especially beneficial. The early arrival in this space was the Jefferson National Monument Advisor variable annuity, with more recent contenders like the Symetra True variable annuity. Ironically - relative to traditional investing discussions - one of the most popular aspects of these latest variable annuities is the wide array of tax-inefficient, active, and non-traditional investment options, which are particularly conducive to variable annuity tax-deferred wrappers.
Of course, if the annuity is too expensive, any benefits of tax deferral will be completely undermined by the cost drag - and historically, variable annuities have been very expensive, making it difficult to justify them for tax deferral in many situations. The new generation of variable annuities, however, are extremely low cost; the Jefferson National annuity is a flat $20/month (albeit supplemented by transaction fees and/or 12(b)-1 fees on many of their underlying fund choices), while the Symetra annuity has a mortality & expense charge of 0.60% (but the underlying funds are generally the lowest cost institutional options and have no 12(b)-1 or other hidden fees at all). And the contracts are intended to provide maximum flexibility; as a result, there are no surrender charges (although the client would still have to contend with income tax consequences and a potential income-tax-driven early withdrawal penalty).
To be fair, the Jefferson National and Symetra annuities have no advisor compensation tied to them, as they are targeted towards RIAs in particular - which means if the advisor is going to separately charge an ongoing management fee, the total cost to the client would be higher, although the fee can (and typically would) be paid with outside funds (as extracting a fee from a variable annuity to pay an outside investment advisor is generally an undesirable taxable distribution). Other contracts, targeted for those registered under FINRA, have advisor compensation built in; for instance, another contender in this space is the Jackson National Elite Access variable annuity (no relationship to Jefferson National), which has an M&E and administration charge of 1%, but part of that expense is used to cover ongoing management and service fees to the broker.
Variable Annuities As An Asset Location Tool For Portfolio Design?
Of course, the caveat to all of this is that tax deferral is only worthwhile when the cost of the variable annuity is low enough that the drag of expenses doesn't undermine all the benefit of tax-deferred compounding. But that is the fundamental point of these next generation annuities - to eliminate the (expensive) living and death benefit annuity guarantees that have been so popular for the past 10-15 years, and instead to focus on providing the most cost-efficient vehicle possible to house the most tax-inefficient investments the client owns.
Accordingly, the potential for this next generation of variable annuities is to alter the standard approach for portfolio design - by providing a new, and flexible, way to house the most tax-inefficient investments in the portfolio. While many advisors already have a heavy focus on the "asset location" decisions of the portfolio - which investments should be held in Roth versus IRA versus taxable accounts - the constraint is that for many clients, there may not be very many tax-deferred or tax-free assets yet, and it's difficult to change that quickly due to contribution limits (and almost impossible to manage for ultra-high-net-worth individuals who simply can't get a material amount of their wealth into retirement accounts).
The next generation of annuities like those from Jefferson National and Symetra then provide a new viable alternative - a relatively low cost way to buy access to tax-deferral, specifically to provide a location for the most tax-inefficient investments in the portfolio. In other words, variable annuities are taking on a new potential role: "on-demand tax-deferred asset location" for investors who are willing to pay a relatively modest fee for the benefit (assuming, of course, that the funds really are "long term" such that the age constraints on variable annuity withdrawals won't be an issue).
Going forward, the relative appeal of using variable annuities as a tax shelter for tax-inefficient investments will depend in part on how the fiscal cliff resolves: higher tax rates, and/or a loss of tax preferences for qualified dividends and long-term capital gains will make tax-deferral more appealing, while tax reform with lower rates may reduce their relative benefit. Nonetheless, the lower the cost for the annuity, the easier it is to justify for tax deferral at any material tax rate, so the pressure is already on for these next generation annuities to maintain low costs and drive them even lower.
Whether these next generation investment-only variable annuities truly gain further momentum remains to be seen. But the bottom line is that as annuity companies struggle to figure out how to gather assets and remain profitable in an environment where living and death benefits are difficult to price favorably and hedge effectively (with the risk of another bear market putting further stress on the company), expect to see many more companies launch annuities to compete in this new direction, which is both lower risk for the annuity company and a more flexible way for an investor to use a variable annuity as a part of the overall investment pie.
Michael Kitces is the co-author, with John Olsen, of The Advisor's Guide To Annuities.
(Editor's Note: This article was included in the Nerdy Finance #19 Carnival on NerdWallet, the Carnival of Money Pros on Making Sense of Cents, and also the Carnival of Retirement on the Investing Money blog.)
Michael, some of these products are quite good. I have been using the JN fee-only VA for a while now, and it is a great tool. It’s only effective in very specific situations, and you really need to a minimum amount to put in (otherwise, the fixed monthly fee erodes the cost-effectiveness of using it).
I typically use it in two scenarios: Most commonly, if I come across a client that has an old fixed annuity that is expiring and with rates where they are now, you need a better alternative for their annuity money until *someday* when rates come back up. I don’t like to lock someone into a 5 or 10 year annuity at 1 or 2%. Years ago we would just re-up the fixed annuity or move to SPIA if they needed income or whatever. Now you have the flexibility to invest the money.
The second scenario is similar as you described – when a client has excess cash that they want invested relatively conservatively but doesn’t want to be paying taxes on income every year – specifically bond income. This is less common, but still a situation that exists.
I will also use it on occasion if a younger client was (mis)sold an expensive VA that they don’t need, that’s out of surrender, but we don’t want to incur any taxable gains.
Some good content here on variable annuities. It will be interesting to see what the next generation of variable annuities will offer. Clearly, the VA’s created over the last 7 years were not priced correctly as numerous variable annuity companies have closed shop, have sold assets, and even offered their clients to get their money back just for walking away. Moreover, variable annuity sales were down quite a bit this year (2012). Check out a relevant blog on the subject here – http://blog.annuitythinktank.com/variable-annuity-sales-fall/
Great insights as always, Michael. Do you happen to know the licensing requirements for an RIA to utilize products like Symetra with clients? Is a life licenses and/or series 7 required?
Kenneth,
Most of the companies that are targeting RIAs have solutions to allow the RIA and their clients to utilize annuities despite the fact that many RIAs do not maintain a broker/dealer license (not to mention having taken a fresh Series 6 or 7).
You’ll have to contact the companies directly to understand how they work with RIAs, as it seems no two companies are quite the same. But most of them have tried to establish solutions that do NOT require independent RIAs to create a B/D relationship they don’t already have.
Many states may require a state insurance license, though, as in some states just advising ABOUT annuities or insurance triggers a requirement to have a license (regardless of whether any commissions are involved). But in any event, that’s a state-by-state issue.
I hope that helps a little!
– Michael
Very helpful. Thanks, Michael.
We have been using the JeffNat MA Annuity for this very purpose for the last couple of years. We have increased our usage even more this year, as we prepare client’s for the 3.8% Medicare tax. We use the anuity to shelter tax inefficient investments, such a high yield bonds, REITs or International Bonds, and reduce their net investment income at the same time. This is predicated on their not having enough deferred assets elsewhere to shelter these assets. The discovery of the non-qualified stretch option open to beneficiaires of VAs made them even more appealing, since we previously had concerns about them becoming a ‘tax trap’ where investors resisted taking withdrawals for fear of incurring taxes and what the impact for their beneificaries would be. With them offering a similer stretch option of an IRA, this makes that far less of a concern. Great tool for total portfolio allocation.
The trouble I have with the concept of asset location as a major concern with investment management is that it makes keeping a client’s overall asset allocation difficult in that maintaining certain asset classes in tax-deferred accounts i.e, bonds, and others in taxable accounts i.e, stocks, makes rebalancing quite difficult when limited by how much can be contributed to taxable accounts. This coupled with that it typically takes years, even decades, for the benefits of tax deferral to be recognized. I think that selecting an appropriate mix of low-cost, globally diversified funds and rebalancing when needed meets the needs of most clients without letting the tax tail wag the dog, so to speak. Michael, you are much more adept at advanced tax planning than I and I’d love your feedback on the subject.
James,
I certainly agree that the tax tail shouldn’t wag the investment dog (notwithstanding my passion for tax planning).
But that doesn’t necessarily undermine the importance or value of asset location. It simply means that the asset ALlocation is determined first, and the asset location of WHERE the investments go is second.
That doesn’t mean you can’t still create value by making good decisions about where the assets go once you’re ALREADY decided what to buy, and/or enhance value by taking investments that you already intend to own and sheltering them in more tax-efficient wrappers.
Yes, the process is more complex, but that’s also part of the value proposition! If it was easy, everyone would be doing it already. 🙂
– Michael
That makes good sense. I would imagine it will become more important as tax rates increase with particular attention paid to high income and high net worth folks as well.
People need to take the time and become more educated and make their financial decisions. After all, who is more concerned about your own finances than you. Control your own investments, don’t pawn off the responsibility to others who treat you as one of the pack and charge high fees.