From the February 2007 issue of Wealth Manager Web • Subscribe!

A Steady Stream

Recently Helen Modly advised a 70-year-old client to purchase an annuity--advice she would not have imagined herself giving 10 years ago. "Like a lot of financial planners, I hated annuities," says Modly, who is executive vice president of Focus Wealth Management in Middleburg, Va.--a fee-only financial planning and asset management firm. This particular client, however, was in poor health with assets being eaten up by healthcare expenses. The situation created enormous stress for the client, who feared outliving her assets.

Modly's solution? One-half of the remaining assets were invested in an immediate annuity offered by USA with no upfront commissions and the highest monthly payments available in the industry. "Now the client is not worried about running out of money," she says.

As far as fee-only advisors have been concerned, annuities have long languished in the financial dog house--considered too expensive and too restrictive. Modly points out that putting assets into an annuity means there is less capital to pass on to heirs, less capital for emergencies and, if opportunities arise, less capital to invest.

Richard Freeman of Round Table Services LLC, a fee-based advisor in Westport, Conn., agrees: "An annuity eliminates market and longevity risk, but you have to give up liquidity and control," he says.

Attitudes, however, are slowly changing. With private sector defined benefit plans going the way of the dinosaur, the fate of Social Security unknown and increasing numbers of clients facing significant longevity risk, fee-only advisors are reconsidering annuities to add a guaranteed income component to clients' retirement portfolios. Structured properly--and with an eye on expense--there is a place in just about everyone's portfolio for an annuity, says Dan Yu, a senior manager at Eisner LLP in New York.

"Years ago I never would have recommended an annuity," Modly admits. Clients usually had income from defined benefit plans and a minimal chance of living past 100. Today, however, advisors have to plan for increased longevity risk with few clients having the security of a guaranteed lifetime income stream. A mortality table may indicate that the client will live to 85, but clients currently in their 50s and 60s could conceivably live to 100, 110 or even 120. "It's not so much that I like annuities," says Modly, "but the reality is that the amount of capital [clients] have to retire on may not be enough for traditional distribution planning."

Clients with a large enough capital pool generally have no need for an annuity, the experts say. If, however, a client has limited financial resources and no retirement plan pension, a fixed, immediate annuity may be a solution. If clients have to withdraw 5 percent annually from their portfolios to meet fixed expenses, an annuity sizeable enough to cover those expenses, along with other fixed income sources, may be in order, says Modly.

Yu recommends that clients take 10 to 15 percent of assets outside of tax-sheltered vehicles to purchase fixed immediate annuities. For example, says Yu, a 65 year old with $500,000 in an IRA and outside assets of $2 million can take $200,000 of the outside assets to buy an immediate annuity contract that will produce about $10,000 in income annually. A client can then balance out the conservative nature of the fixed income annuity investment by investing in more aggressive investments inside the IRA, he adds.

The client's age should also be considered. "Buying an annuity at 70 is a good idea; it isn't when you're 50," says Freeman. Modly also recommends waiting until the client is 70 to protect against inflation.

For the most part, the annuities advisors are now cautiously recommending to their clients are fixed immediate annuities. Deferred variable annuities are still in the doghouse.

"Deferred annuities are basically an expensive way to buy a basket of mutual funds," says Modly. "It's better to invest the money directly and then take the money at retirement and buy a fixed, immediate annuity."

Not necessarily, according to Aaron Grey, director of operations for fee-only advisory firm Denver Money Manager LLP in Denver. "Variable annuities have their place in retirement planning, and can be advantageous for the client," Grey says. For example, if clients receive large bonuses or inheritances, after maxing out qualified retirement plan contributions, variable annuities provide additional tax-deferred growth.

Variable annuities are tax-deferred, but you can get the same effect by investing passively, argues Yu. "You'd be better off if you invested in a tax-efficient, taxable mutual fund account, such as an Index fund or ETF," Yu says. And, he points out, when the passive investment is sold, the client pays capital gains taxes. But the same investment in a variable annuity would incur ordinary income tax upon distribution.

If the investment objective is solely to minimize taxation, then passively investing makes sense, counters Grey. If the client wants to utilize a more active management investment style and defer taxation, however, he argues that a variable annuity may be more appropriate.

Furthermore, comparing fees on variable annuities to those of mutual funds is like comparing apples to oranges, says Sidney J. Smith, Jr., a vice president of annuity development at Axa Equitable in New York. Clients purchasing variable annuities are not purchasing an investment inasmuch as they are purchasing insurance, Grey agrees. For clients who want to be guaranteed a minimum level of income in retirement, a variable annuity may be the appropriate strategy, provided they are fully aware of what they are paying to get that insurance. "The insurance company is taking the investment risk off the client, and the client has to pay for it," says Grey.

For example, one of the most significant differences between a variable annuity and a mutual fund is that variable annuities can guarantee the return of principal, says Robert M. Goldenberg, also an Axa Equitable vice president, annuity development. If a person invests $100,000 in a mutual fund which is worth $60,000 when he dies, his heirs only get $60,000. If $100,000 is invested in a variable annuity, however, his heirs can get $100,000 if he dies prior to distributions, even if the underlying accounts are only worth $60,000.

Variable annuities can also guarantee a client a string of income no matter how long they live, no matter how the market does, says Smith. For example, a 60year old can invest $100,000 in a variable annuity today, and be guaranteed at age 70 to receive approximately $12,000 annually for the rest of his life. If a client's accounts do better then expected, he adds, he could get more than $12,000 annually.

"There's a premium for that guarantee," says Smith, "but it's valued by clients and often worth it to have the security." According to Morningstar, the average annual fees on B-share mutual funds are 192 basis points. According to Morningstar's VARDS, the average annual fee on a variable annuity with a standard death benefit is 232 basis points, and it costs an additional 50 to 70 basis points for guaranteed income benefits. Thus, argues Smith, for approximately 100 additional basis points annually, clients can guarantee their original investment as well as a retirement income stream. Furthermore, he adds, by guaranteeing a minimum income stream, clients can then invest remaining assets more aggressively.

Still, most advisors remain unconvinced. Yu, for one, argues that if variable annuity costs were to come down, he would view them more favorably. According to Morningstar, average insurance charges are 1.35 percent of invested assets annually. For example, a $100,000 variable annuity typically charges $1,350 annually; the cost for a $1 million VA would be $13,500 annually.

The industry seems to be listening, and lower cost products are coming on the market, including new products specifically designed for fee-only advisors. "The traditional argument against deferred annuities was that fees ate into savings; we now have tax deferrals at a low fee," says Laurence P. Greenberg, president and CEO of Jefferson National Life Insurance Company in New York.

Jefferson National's Monument Adviser is a variable annuity with a flat insurance fee of $20 monthly, or $240 annually--no matter how much the client invests. There are no commissions, no surrender charges and more than 150 investment options with no upfront loads and fees ranging from 20 basis points to 100 basis points. Monument Adviser was created specifically for fee-based advisors, to fit with their business model, says Greenberg, and is an appropriate investment for any client who has maxed out their 401(k) contributions and still wants a tax deferred investment vehicle.

Still, some advisors believe that insurance companies need to create more new products. For example, says Modly, an affordable fixed annuity with a cost of living adjustment. Right now, she says, purchasing a COLA on a fixed annuity is too expensive. If clients could get inflation protection on annuities at a reasonable cost, she says, she would recommend fixed annuities for clients in their 50s and 60s.

Another product that would be welcomed is an annuity younger people could purchase that guaranteed a fixed level of income in the future with no investment risk. "I hope that the financial industry comes up with a financial solution to this problem that doesn't impoverish people trying to get it," says Modly. "The need is there but the products aren't."

All those baby boomers hitting retirement may revolutionize the annuities market, says Grey. If annuitizing all or part of retirement accounts becomes the norm, fees may come down as competition heats up. If younger workers see their elders struggling in retirement, they may seek products that remove investment risk and guarantee income, and vendors will develop the products to meet the market, he adds. "If anyone developed a well priced product that guaranteed income and took the investment risk off the individual, money would flow into it," Grey says.

And finally, advisors may face fiduciary liabilities if they simply dismiss annuities out of hand. Since advisors base most fees on assets under management, it could be argued that an advisor counseled against purchasing an annuity out of fear of lowered management fees-- i.e., if an advisor does not recommend an annuity and there is subsequently some kind of stock market crash, a client could claim that the fear of a reduction in fees motivated the advisor to not recommend the annuity. The situation would be even worse if a client inquires about an annuity, the advisor dismisses it, and the market crashes. To protect themselves, fee-only advisors should provide clients with a detailed, reasoned analysis as to why they believe an annuity is not appropriate to a particular client.

With the wild stock market fluctuations of the last decade, there is no doubt that guaranteeing an income stream has a lot of appeal--even among advisors. "I think that when I retire, I'd like part of my income to be guaranteed," says Yu. Annuities, however, are not a panacea, and while advisors should give them more consideration than they have in the past, they are far from being a no-brainer. "Fewer and fewer people have defined benefit plans, and more people are on their own to save for retirement. Immediate annuities are a substitute, but it's important to think them through when you buy," says Freeman.

Elayne Robertson Demby, JD, has covered executive compensation, employee benefits, and financial issues for more than 10 years.

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