Distribution Planning Articles

Immediate annuities can be a valuable component of a high-net-worth client's financial plan. Here's why.

Annuities are hot - in some ways maybe even too hot for many brokers to touch these days. Regulators are closely scrutinizing sales of the product, especially variable annuities, because of allegations of unsuitability and sales improprieties. Many financial journalists warn their readers to avoid annuities altogether because of costs. And many brokers shun the products because of their complexity.

In my view, much of this negative attention is misdirected. By lumping all types of annuities into one category, viewing them as a product rather than as a set of solutions, and focusing on overhead costs, most people with an interest in the product - investors, brokers, regulators and the media - tend to ignore the unique ways annuities can meet certain investor needs. In particular, high-net-worth investors approaching retirement or already in retirement can find some annuities to be a very useful tool in meeting goals in the areas of retirement planning, estate planning and investment portfolio planning.

Retirement Income Planning

Where income is a primary goal, annuities often make sense. After all, income is supposed to be what annuities are all about. Advisors sometimes lose sight of this fact because the terms "annuities" and "deferred annuities" are used interchangeably, and deferred annuities too often are marketed as accumulation instruments.

The majority of annuities sold are the deferred variety. And what's being deferred is annuitization, or the conversion of the accumulated value of the deferred annuity contract to a regular income stream after at least a year from the time of purchase, if ever. Only about 2 percent to 4 percent of deferred annuity contracts are ever annuitized.

Immediate annuities, by contrast, are structured to begin making payments within 12 months of policy issue. Often, they begin as quickly as one month after issue. Payments may be for a specified length of time (a "period certain" annuity), for the annuitant's lifetime (a "life only" annuity), or for lifetime with some guarantee of a minimum total payout, such as a "Life and 10-Year Certain" contract (where payments continue for the life of the annuitant or, should the annuitant die before 10 years' payments have been made, to beneficiaries for the balance of those 10 years' payments). "Joint and Survivor" life annuities also are available, in which payments are made so long as either of two annuitants is living. These optional annuity payout arrangements are variations on a theme, and that theme is income.

Where ensuring an adequate retirement income is a key objective, the immediate life annuity is an obvious candidate for consideration because it guarantees an income for the annuitant's lifetime, no matter how long that is. But will that income be adequate? Critics of immediate annuities point out that the cost of the income guarantee is too high, particularly when interest rates are very low. In effect, the annuity purchaser is locking in a low rate of return. While it's true that the amount of each payment guaranteed in an immediate annuity varies directly with the interest rate an issuer assumes it can earn on the purchaser's dollars, the focus on interest-rate risk is overwrought.

If the goal is to produce an adequate income for life, no matter how long that is, then surely mortality risk ought to be a serious consideration, too. The client may not die at or before his statistical life expectancy; by definition, half of us do not. And if a client's family has been particularly long-lived, the risk of outliving one's money should be of even greater concern.

What about inflation risk? Critics of immediate annuities often insist that purchasing a fixed income ignores that peril. They're right. But not all immediate annuities guarantee a fixed income. Variable immediate annuities, for instance, provide lifetime income through payments that vary with the performance of investments in separate accounts. There also are non-variable immediate annuities where the annuity amount increases annually by a pre-determined factor.

Above all, in comparing immediate annuities to other investments in terms of providing adequate retirement income, remember that it's not an "either/or" proposition. Using just part of a client's total portfolio to purchase an immediate life annuity to provide a base of guaranteed income (and investing the rest in different ways) offers several advantages:

• Reduced Negative Dollar-Cost Averaging

An investor accumulating a portfolio by making regular, equal-dollar contributions benefits from fluctuations in the price of those investments by being able to purchase more shares. But if prices are falling, investors taking regular, equal-dollar distributions suffer from these same price fluctuations. In effect, he or she is suffering from negative dollar-cost averaging: As share prices decline, more shares must be liquidated to provide the same required income. Thus, fewer shares will exist to benefit from future price recoveries. Annuitization provides the regular income.

• Peace of Mind

Among clients whose portfolios have suffered during a market decline, one of the most frequent concerns is how the fall-off will affect income. To the extent that a client has chosen annuitization and his or her income remains constant or increases at a known rate, this concern - and the anxiety it evokes - is reduced.

• Impact on Portfolio Failure Rate

Since one major purpose of a portfolio is to produce retirement income, advisors often construct models of how much income a portfolio reasonably may be expected to generate. In one such study, authors John Ameriks, Robert Veres and Mark J. Warshawsky examined several model portfolios. They used actual historical data and Monte Carlo simulations and demonstrated that annuitizing a portion of each portfolio would produce a significantly greater probability of producing a required income throughout retirement than investing the same portfolio without annuitization.

But what about deferred annuities? Do they work to ensure adequate retirement income? They can, but most deferred annuities are sold as investment vehicles for accumulating capital. The truth is, all annuities - deferred or immediate, variable or non-variable - are chiefly risk management instruments. Policy costs, which so often are condemned by critics as excessive, are all insurance charges that compensate the insurer for providing guarantees against adverse performance. These guarantees - which can assure payouts, minimum income benefits, partial withdrawal benefits, accumulation benefits and minimum death benefits, for instance - differ greatly. Their value to a particular client will depend upon that client's specific concerns. Some guarantees may be irrelevant to a particular client, and others may be too costly for the benefit they provide. Certainly, no responsible advisor would recommend that a client purchase a benefit which that client considers valueless or not worth its cost. But many of the benefits available in some variable deferred annuity contracts are generally not available in most investment alternatives. Whether they're worth the price is a question for the client to decide when fully informed of the alternatives.

Estate Planning

How well an annuity will work to achieve a client's estate planning goals depends upon the client's specific goals and the kind of annuity that is being considered.

Immediate annuities, of course, are all about income. They can transfer wealth to heirs only to the extent they include some kind of refund provision, such as a 10-year certain feature. If the client outlives this refund feature, or if the annuity provides none, there is no value to pass to heirs at the client's death or to be included in the client's estate. Often, an immediate life annuity will provide a higher income than could be obtained with certainty from the same amount of capital invested elsewhere. When this is the case, a client may feel comfortable gifting more of his other assets to heirs than if he had to live on uncertain investment income from those assets.

An interesting post-mortem estate planning application of an immediate annuity involves its purchase by the trustee of a client's credit shelter trust. Such trusts often are designed to provide for a surviving spouse and for remainder beneficiaries, perhaps the decedent's children. One problem with administering such a trust is that investments that provide the most income often provide little or no growth, and vice-versa. This can present the trustee with a dilemma in trying to create and manage a portfolio that seeks to do both. Devices such as the total return unitrust offer a solution, but state laws regarding them vary and often are restrictive. Where the estate plan seeks to provide the decedent's surviving spouse with a certain income for life, the trustee might purchase a life annuity in which the surviving spouse is named as annuitant. The older that spouse is, the more income per invested dollar can be assured to her. Any trust corpus not used to purchase the annuity can be invested purely for growth.

Deferred annuities often are used in estate planning, especially in informal estate planning, because annuity death proceeds are payable to named beneficiaries directly and generally bypass probate. Any annuity gain is tax deferred, and in the case of non-variable contracts, principal (including all prior interest credited) is guaranteed against loss. These are certainly valuable benefits. However, purchasers of deferred annuities often buy these contracts with money they do not expect to use during their lifetime but wish to leave to heirs. In my opinion, this is usually a mistake, for several reasons.

First, the entire death proceeds of the annuity are includible in the decedent's estate, if decedent owned the contract. Second, there is no step up in basis applicable to deferred annuities. Un-taxed gain included in the death proceeds of non-qualified annuities is "Income In Respect of a Decedent" and reportable on the beneficiary's income tax return. If the beneficiary is in a higher marginal tax bracket than was the annuity owner during his lifetime, the benefit of tax deferral is reduced by this negative leverage. This is particularly so when the annuity death benefit is large and is taken by the beneficiary in a single year. Moreover, this income tax liability is in addition to estate taxes on the annuity.

Third, the gain in a deferred annuity is always taxed as ordinary income. Similarly, enhanced death benefits offered by some variable annuity contracts (which often are marketed as tools to help pay estate taxes) also are taxed as ordinary income "gain" and are includible in the decedent annuity owner's estate.

For the purpose of maximizing wealth to the next generation, an immediate annuity is generally an inappropriate tool, except insofar as the assurance of annuity income allows the estate owner to transfer more to heirs by other means. Generally speaking, a deferred annuity is not an efficient device for this purpose either, especially when estate taxes are a factor.

To preserve capital, however, deferred annuities edge out immediate annuities. Non-variable deferred annuities offer guarantee of principal (including all prior credited interest) and may offer multi-year minimum interest guarantees. Variable contracts provide a guaranteed minimum death benefit and, perhaps, a guaranteed accumulation benefit. Either or both might produce a significantly larger pre-tax value to heirs, after a significant market decline, than investment instruments lacking such guarantees. Of course, if a guaranteed after-tax inheritance is a major planning objective, life insurance is generally a far better solution. Life insurance proceeds generally are income tax-free and may escape death taxes as well. Clients contemplating a single premium deferred annuity (variable or non-variable) "for the kids" ought to consider a single premium life policy (variable or non-variable) before making a decision.

A common pitfall in the use of deferred annuities in estate planning is naming the client's revocable living trust as beneficiary of the annuity. Many practitioners recommend this arrangement, unaware of its potentially serious drawbacks. At the death of an annuity owner, the beneficiary generally may take proceeds in a lump sum; within five years; as an annuity that does not extend beyond the beneficiary's life expectancy, or - if the beneficiary is the surviving spouse of the owner - he or she may elect to treat the annuity as his/her own, continuing tax deferral of gain.

If the annuity is payable to a client's trust, that last option is not available. And I have a serious question as to whether the third option could be elected by the trustee. The unavailability of these options to an annuity owner's surviving spouse, who is beneficiary only in her capacity as trustee of his living trust, could be the stuff of litigation.

With regard to asset protection, annuities may offer substantial advantages. Many states have enacted statutory protection for annuity contracts. The conditions and extent of such protection vary widely, and advisors using annuities should be familiar with the rules in the states in which they practice.

Investment Portfolio Planning

The suitability of an annuity for a client's portfolio can be assessed by the same process used to determine the suitability of any other investment: What is this instrument supposed to do for the client? Annuities are not primarily an investment, but a risk management tool. Immediate annuities do not accumulate wealth; they distribute it. Deferred annuities can serve as accumulation devices, but they're designed to produce income. The costs in deferred annuities, especially in variable ones, are primarily charges for assured minimums with respect to that income.

If we view a deferred variable annuity purely as a device for accumulating capital, we miss the point entirely: Annuities are about reducing risk.

The chief concern for many clients, including wealthy clients, is retirement income planning. Their Number One objective is ensuring adequate retirement income. Their single biggest risk can be stated in the form of a question: What are the chances their account balance will fall to zero before their blood pressure?

None of us know the precise answer to that question. And for that reason, annuities - whether deferred or immediate, variable or non-variable - can be part of a coordinated overall plan to help clients address and reduce that risk.