Articles About Annuities

Annuities have long enjoyed preferential treatment under the tax code - so extensive, that they merit an entire portion of the tax code, IRC Section 72, all to themselves. The favorable rules are generally intended to support the use of annuities as a vehicle for retirement savings and/or retirement income... and as such, the rules generally only apply in situations where annuities are owned directly by individual, living, breathing human beings who may in fact someday retire (known in the tax code as "natural persons").

Accordingly, whether annuities owned by trusts still enjoy tax-deferred growth depends upon the exact details of the trust. The rules do allow that when a trust owns an annuity "as an agent for a natural person" the contract can still keep its tax-deferral treatment, such as when it's owned by a revocable living trust; even if merely all the beneficiaries of the trust are natural persons, such as with a bypass trust for the benefit of a surviving spouse and children, favorable treatment is still available. However, if other beneficiaries are involved - even and including charities - a trust-owned annuity may lose its preferential treatment.

An even more complex point of intersection between annuities and trusts is when annuity contracts are transferred to/from a trust. The problem is a key section of the tax code designed to prevent the unrealized gains of annuities from being shifted to another individual through gifting; as a result, if an individual transfers an annuity "without full and adequate consideration" its gains are immediately recognized. By this rule will not apply to transfers to a revocable living trust, or most types of transfers out of a trust, in the case of some common estate planning techniques - like gifting an annuity to an Intentionally Defective Grantor Trust (IDGT) - the situation remains unclear, and clients and their advisors must be cautious not to accidentally create an unfavorable taxable event!

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Since the tech crash, it has been increasingly popular to purchase variable annuities with "guaranteed living benefit" riders to help protect retirement income against the risk of a market catastrophe. The basic premise of the contracts is rather straightforward: for a modest cost, the insured can transfer the risk of a severe market decline to the insurance company, and remain assured that guaranteed retirement income will be available for life, undiminished by the market decline. In the meantime, the annuity owner has the opportunity to stay invested in the market, with the hopes of generating an ever greater upside (albeit reduced by the costs of the annuity).

The problem, however, is that unlike most types of insurance - where the law of large numbers allows the insurance company to have relative certainty about the timing and magnitude of potential claims - in the case of annuities with income guarantees against a market decline, the insurance company faces virtually no risk exposure for any of its policyowners, until a major market decline actually occurs... and then, suddenly, the insurance company must set aside reserves for everyone, all at once. The end result is that market volatility can end out creating drastic volatility in the required reserves and profitability of the insurance company - to such an extent that in the past several years, many major insurers have decided to stop offering the guarantees altogether.

In the aggregate, the problem is that having a large group of prospective policyowners transfer their exposure to market risk to the insurance company may seem like the risk is being transferred from the policyowner's perspective, but the risk is actually being concentrated from the insurance company's perspective, in a remarkably undiversified manner. As a result, the policyowners actually face the danger of turning what was a systemic risk exposure to overall markets into a very specific, undiversified, unsystematic risk exposure to the credit quality of a particular (insurance) company instead. And for those who fear the danger of a "black swan" event, the reality suddenly becomes clear that the kinds of black swans that could be a blow to markets may actually be an even more severe blow to the insurance companies trying to guarantee against them, as was evidenced by the need of at least one annuity provider to access Federal TARP funds for liquidity in the immediate aftermath of the financial crisis.

Ironically, it turns out the best alternative may simply be the solution that advisors recommended before such annuity contracts were available in the first place: to invest more conservatively, and spend more conservatively, and simply stay the course and weather the storm. After all, conservative spenders following a safe withdrawal rate approach have largely recovered their declines since the financial crisis, while many insurance companies have left for good; similarly, while the safe withdrawal rate weathered the Great Depression, many insurance companies did not. Of course, in today's marketplace, the annuity companies have finally figured out how to proper structure, constrain, and price annuity guarantees to manage their risk exposures and make the products economically feasible to be offered; yet the outcome of such pricing may be leading to the point where their floor-with-upside guarantees are no longer an appealing trade-off for the (new) cost.

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The fundamental promise of guaranteed living benefit riders on annuities is the potential to invest more aggressively for growth, while maintaining an income guarantee no matter what, in case things don't work out as expected. In other words, at the most basic level, using income guarantees is a "floor with upside" approach to investing for retirement income. The floor may not be the most appealing income level, but it's tolerable on the downside when there's a hope and real chance that things could turn out much better.

Yet in today's environment, the combination of lower prospective returns and higher annuity costs is presenting a troubling new alternative: that guaranteed income riders no longer representative a "floor with upside" but instead are a floor that will be almost impossible not to fall down to and hit. In other words, what was supposed to be a floor that would only be relied upon in a worst case scenario may instead turn out to be the best case scenario and an unavoidable outcome instead!

Unfortunately, though, if the reality is that the income guarantee of the annuity is no longer a worst case scenario but actually a best case one, then it no longer represents the fundamental trade-off that made it so attractive in the first place. Instead, if there really is little upside to the income guarantee, then it may be more appealing to skip the guaranteed living benefit rider altogether and instead just buy a single premium immediate annuity for a comparable guarantee and invest the rest, or just invest and spend conservatively using a safe withdrawal rate approach and simply ride out any intervening market volatility!

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A classic challenge of beneficiaries of inherited (non-qualified) annuities is that they have been "stuck" with whatever contract was originally owned by the decedent, often locking the beneficiary into a series of investment choices (or lack thereof) that limited the ability of the contract to be invested accordingly to his/her needs and goals, especially when a fixed annuity was inherited by a young beneficiary who wanted to invest for long-term growth. The only alternative: beneficiaries who wanted to reinvest the proceeds were forced to liquidate the contract, paying any/all gains at that time (at ordinary income rates), and then reinvesting whatever was left over.

In a new private letter ruling from the IRS, though, the rules are now changing. PLR 201330016 granted the beneficiary of a series of several fixed and variable non-qualified inherited annuities to complete a 1035 exchange of those contracts into a new variable annuity to gain access to more appealing investment returns. In the IRS' viewpoint, the beneficiary-as-inheritor had sufficient ownership and control of the inherited annuity to allow the exchange, and permitted the exchange to occur, as long as the technical requirements for the 1035 exchange were honored, and the beneficiary committed to taking post-death distributions from the new annuity at least as rapidly as were occurring under the old contract.

While this is ultimately "just" a private letter ruling, and not technically binding, it seems likely the IRS will continue to follow the ruling as long as it is not abused. Accordingly, though insurance companies will need to decide whether they individually will comply, and prepare the appropriate forms and paperwork to ensure that the technical requirements stipulated in PLR 201330016 are honored, the reality is that this new ruling may have finally opened the door for beneficiaries of inherited non-qualified annuities to gain a new level of flexibility to make decisions about what to do with inherited annuity contracts, and exchange accordingly as desired.

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From the perspective of economics and life cycle finance, the immediate annuity is often viewed as the perfect retirement vehicle; in research dating back to Yaari (1965), it has been shown that for someone whose primary concern is outliving his/her money (as opposed to leaving a bequest to future generations), investment dollars should be annuitized to generate a superior return over bonds (due to mortality credits) while protecting against mortality risk.

Yet economists have long struggled to explain the so-called "annuity puzzle" - the fact that while the research suggests annuitization should be optimal, in practice remarkably few people ever choose to do so. Does that mean they're all just being driven by an irrational decision-making process and just need to be better educated to understand the true benefits of immediate annuities, or is there some other factor at play?

In new research, researchers Felix Reichling of the Congressional Budget Office and Kent Smetters of the Wharton School of Business think they have found a new way to explain the puzzle: the fact that the value of an immediate annuity changes over time due to incremental (and sometimes shocking) changes in health and mortality. In fact, it can be the worst of both worlds - severe health events can simultaneously reduce life expectancy (decreasing the remaining value of the annuity) and increase cash flow needs (to pay for the necessary care). And when viewed in this dynamic context, the value of annuitization can be quite risky indeed; so much, in fact, that Reichling and Smetters find that for those who are relatively risk averse and/or have limited retirement assets, that the most rational annuity allocation might be to avoid them altogether, and the ideal might even be for many to have negative exposure and "short" annuities instead!

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Over the past 15 years, the variable annuity industry has experienced a tremendous amount of change - from the explosive rise of variable annuities with guaranteed living benefit riders for retirement income leading up to the fall of 2008, to the dramatic pullback of many insurers away such offerings in the aftermath of the financial crisis. While ultimately many annuity owners who purchased contracts prior to 2008 have been happy with their contracts and the guarantees, the same has not been true of the annuity companies who offer them, as a rising number of insurers have been offering buybacks to annuity owners that offer contract value increases or outright cash in exchange for releasing the company from their guarantees in order to reduce exposure.

In a disturbing new trend, though, several annuity companies have begun to make changes to the investment offerings, ostensibly to simply change the lineup of funds being offered, but done in a way that increasingly appears to change the rules of the game for existing annuity holders after the fact. The first shot across the bow came earlier this spring from AXA, who in the process of rotating investment offerings in a 'routine' prospectus change indirectly defaulted a large number of annuity holders into more conservative investments than they may have originally selected (and often into their own affiliate-managed funds to boot). In a more concerning shift, now Hartford has decided to change its investment offerings as well, and actually require policyowners to voluntarily adopt the new investment offerings or lose their annuity guarantees! In other words, a number of contract owners with what were purported to be lifetime guarantees are now renewed to complete a "renewal" process by October 4th or permanently lose their lifetime income protection!

While such a move is certainly not popular, the reality is that because several companies making recent changes - including Hartford - are not in the business of offering variable annuities anymore, the potential fallout to the companies in damage to their brands is arguably limited. Nonetheless, this emerging trend to alter annuity contracts after the fact by changing the prospectus and attaching requirements to continue the guarantees puts new pressure on advisors to monitor on behalf of clients, and arguably even advisors who didn't originally sell the annuity could still be liable if they're engaged for ongoing monitoring of the client's comprehensive financial plan and miss a crucial change to the guarantee! As a result, advisors will need to be increasingly diligent in reviewing client annuity contracts, or look to outsource to due diligence services that can help to support the process.

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While some advisors recommend annuities more often than others, virtually any advisor may have to deal with situations where clients have existing annuities. And because of the significant "living" and death benefit riders offered over the past decade, the reality is that the decision about what to do with an existing variable annuity is not as clear cut as it was in the past; in fact, failing to do proper due diligence before recommending a client cancel a variable annuity can land an advisor in more hot water than just selling one in the first place!

Unfortunately, the due diligence process is complicated by the fact that almost no two variable annuity riders work the same, with a broad range of GLWB and GMIB riders from one company to the next, each with their own unique features and benefits. As a result, there's more pressure than ever on advisors to read through the details of each and every contract, to try to make a good assessment of the situation and what the client should do next. On the plus side, though, a growing number of third-party providers are available to assist - including a notable new offering aptly titled "Annuity Review" - giving advisors the opportunity to gain outside expertise to help go through the details of contracts with which they may not be familiar.

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Through the 1980s and 90s when tax rates were higher, variable annuities were a popular tool for tax deferral. However, since the late 1990s, the primary focus of the annuity industry has been on risk management instead, offering a series of living and death benefit features that have provided significant guarantees, but at a significant cost. When combined with tax rates that declined significantly with President Bush’s tax legislation in 2001 and 2003, the benefit of tax deferral associated with non-qualified annuities was simply no longer worth the cost.

In a significant shift, though, an emerging new generation of low cost variable annuities, combined with a significantly more progressive tax system since the American Taxpayer Relief Act of 2012, may usher in a new era for the use of variable annuities, especially when the contracts can be used strategically as an asset location vehicle to shelter high-return but tax-inefficient investments. Consequently, while not long ago it was projected to take a decade or two for the benefits of tax deferral to offset the cost, it now can take as little as a year or two for higher income clients! The end result: it may once again be time to seriously consider the cost of variable annuities as an expense worth paying to harness the value of tax deferral.

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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.

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The variable annuity industry has a long history of criticism, generally stemming from the relatively high cost of their guarantees relative to less expensive investment alternatives. To burnish their value, in the past 15 years variable annuities have stepped up the guarantees that they provide, delivering a far wider range of income and death benefit features. However, in the face of wild market fluctuations – especially the 2008 financial crisis – many critics now also point out that the new guarantees of variable annuities pose new risks about whether the company will even be able to make good on its guarantees when the time comes. Yet the reality is that suggesting that variable annuities are risky and that the companies might not be able to pay on their guarantees would suggest that they’re not charging enough – implying that actually, variable annuities are too cheap, not too expensive! Alternatively, if the reality is that the current world of variable annuity guarantees really are too expensive, then there should be no risk at all, as the companies would have more than enough excess profits to handle the risks. So which is it at the end of the day? Are annuities really too expensive, or are they actually too cheap? Read More...