More On Tax Planningfrom The Advisor's Professional Library
- Taxation of Real Estate Real estate may be used to shelter income and may offer certain tax benefits. However, the type of real estate investment may result in different tax treatment. Learn how to use these investments to help your clients.
- Annuities: Estate Tax The value of certain types of annuities may be included in an estate’s value. Understanding the intricacies of these inclusions is a critically important aspect of estate planning.
Regulators are cracking down on abusive sales tactics by broker/dealers selling annuities. But sales of variable annuities--and, particularly, immediate annuities--continue to grow at a healthy clip. In the first quarter of 2004, total VA assets hit $1 trillion, a level not seen since 2000. Sales of VAs reached $34.4 billion in the first quarter of this year, a healthy jump from $31.7 billion in the first quarter of 2003. "People have not been deterred from investing in annuities as a result of the heightened regulatory scrutiny," says Michael DeGeorge, general counsel for the National Association for Variable Annuities (NAVA) in Reston, Virginia.
In June, the Securities and Exchange Commission and the National Association of Securities Dealers issued a joint report on broker/dealer sales of variable insurance (it's at www.sec.gov/news/studies/secnasdvip.pdf). The report cites "a large number" of investor complaints about being sold a variable annuity without fully understanding the product, or being sold an annuity that was not appropriate for their investment objectives. The SEC and NASD also found instances of brokers recommending annuities to senior citizens and other investors who couldn't afford to buy the products without mortgaging their homes. Other abuses included failures to disclose the fees, risks, and tax consequences of variable insurance products.
NAVA says the report failed to show "that improper sales practices are widespread throughout the variable annuity industry" and maintains that "the vast majority of variable annuity sales are in compliance with SEC and NASD requirements." But SEC Chairman William Donaldson insists that the report's findings "show that many firms should take steps to improve their practices," and that "given the complexity of variable annuities, extra care is required" when selling and buying these products.
The SEC has issued an alert (sec.gov/investor/pubs/varaquestions.htm) reminding investors that annuities aren't for everyone, especially those who need money in the short term or who borrow against their homes in order to afford one. "People don't understand there is a long-term holding period, usually seven years," when they purchase an annuity, says Daniel Reagan, a registered rep at Fleischer Jacobs Group in South Burlington, Vermont.
Recently, the NASD slapped three firms--Nationwide Investment Services Corp. of Columbus, Ohio; its affiliate, Nationwide Securities Inc. of Dublin, Ohio; and American Express Financial Advisors Inc.--with fines for variable annuity sales abuses. In settling with the NASD, none of the firms admitted wrongdoing. But Nationwide Investment Services and Nationwide Securities were fined $175,000 for inadequate procedures and systems governing variable annuity sales, and for distributing advertising and sales material with inadequate disclosures about annuities. American Express was fined $300,000 for inadequate record-keeping. The fines came on the heels of NASD complaints against Waddell & Reed and its president and national sales manager for recommending 6,700 variable annuity exchanges to customers without assessing the suitability of the transactions. Waddell & Reed has denied wrongdoing. The NASD, meanwhile, vows it will rein in "problematic sales practices" in deferred variable annuities--the top-selling contract--through a proposed rule requiring "suitability, disclosure, principal review, supervisory and training requirements that are tailored specifically to transactions in deferred variable annuities."
DeGeorge of NAVA notes that at the end of 2002, deferred variable annuity sales totaled $113 billion, while sales of immediate variable annuities reached only $500 million. But immediate annuities are becoming more popular with retiring baby boomers in need of cash. "Immediate annuities will be more important and play a much bigger role as the baby boomers retire in the next several years, because Social Security is not going to provide enough cash flow to people in retirement," DeGeorge says.
An immediate annuity is purchased with a single premium, and payouts begin a month or so after purchase, DeGeorge says. With immediate annuities, investors take a lump sum and convert it into a lifetime income stream. Deferred annuities are longer-term investments that have an accumulation phase. They can be purchased with a lump sum or through monthly premiums. The money in a deferred annuity builds up over time on a tax-deferred basis. At retirement, the contract owner can begin to take money out of the annuity by annuitizing.
Deferred annuities are generally best for those looking to use the money in retirement, says Reagan of Fleischer Jacobs. While an investor could set up a deferred annuity while young, Reagan warns that the investor should avoid pulling money out of it before he reaches age 59 1/2 because he'll be charged a 10% tax penalty for each withdrawal. Indeed, DeGeorge says a deferred annuity could be a great choice for a 51-year-old like himself who will probably continue working for another 15 years and live until age 82. If a 51-year-old retires at age 65, he'll have another 20 years in retirement, so a "deferred annuity may still make sense" for him because he can "build up money on a tax-deferred basis, and then convert the money to a lifetime income stream to supplement Social Security."
An immediate annuity makes the most sense for an older person looking for some type of lifetime income, DeGeorge says, adding that the majority of people purchasing immediate annuities choose fixed annuities "because they like knowing the amount they will receive each month is never going to vary." Harold Evensky, chairman of Evensky, Brown & Katz in Coral Gables, Florida, says his firm is "really interested" in using immediate fixed annuities for its retirees because the need for cash flow is replacing accumulation as the dominant planning goal.
Reagan says one of the criticisms of deferred annuities is that the investor "defers all of [his] income and then at death the beneficiary is stuck" with paying taxes on the gains in one lump sum. But recent private letter rulings issued by the Internal Revenue Service to some financial services companies allow a beneficiary to stretch out the annuity distributions over time. With the stretch, "the beneficiary can spread the tax payments out over their life expectancy," Reagan says.
To DeGeorge, the biggest challenge facing the annuity industry remains that of meeting the needs of retirees. "There is a tremendous population of people retiring, and there are countless studies that show those people are woefully unprepared for retirement," he says. Most people "haven't saved enough, and haven't planned" for retirement. "Even people who have saved money don't have a plan for how they're going to spend it and make it last throughout retirement." DeGeorge further argues that "many financial planners believe that annuities, on the payout side, do have an important role to play" in clients' portfolios.
But advisors and their clients wonder why anyone should purchase a deferred variable annuity in a qualified tax plan that offers its own tax deferral. One reason: "It's an easy sale" and commission for the broker, and "there are no breakpoints," says Evensky. Another more legitimate reason is that a variable annuity offers investors more mutual fund families to choose from. "If a manager leaves, [the annuity holder] can move to another fund and have no commission cost," Evensky says. "That is a valuable benefit, particularly for an investor that's interested in the ability to switch between management." Yet another reason is the income guarantees offered by annuities, Evensky says.
Putting a VA in a 401(k)
DeGeorge argues that "it's perfectly appropriate" to place a deferred annuity in a tax-deferred plan like a 401(k) because of the insurance benefits it offers. He notes that annuities provide a death benefit that protects money going to the beneficiaries if the value of the investment portion of an annuity should decline. Annuities also offer living benefits that protect contract owners from a downturn in the market while they're still living. "You don't get those types of guarantees if you fund a 401(k) plan with only mutual funds," he says. "If the value of the mutual fund goes down, the fund isn't going to make up the difference; the insurance company offers various guarantees to make up the difference."
Reagan adds that insurers have improved variable annuities by creating more options, guarantees, and riders. "You can have annuities with no surrender charges, traditional surrender charges, and everything in between," he says. Because annuities have become more flexible, it should be easier for advisors to find the right annuity to fit the client's needs. But with the SEC and NASD looking over the industry's shoulders, advisors will need to be extra careful about every sale.
Washington Bureau Chief Melanie Waddell can be reached at email@example.com.