A principal goal of many estate plans is to provide income to the estate owner’s heirs. This goal can often be achieved by using either immediate or deferred annuities. Where the goal is to provide heirs with an immediate income, an immediate annuity may be the ideal mechanism, especially if the income is to continue for the recipient’s lifetime. The certainty afforded by such a contract is sometimes more important than the amount of each income payment or the fact that the annuity income does not preserve principal. This may be particularly appropriate to satisfy specific beneficiary lifetime income bequests from a portion of assets while the remainder passes to another beneficiary.
Where the desire is for the heir’s income to increase over time — perhaps to keep pace with inflation — an immediate annuity providing for known annual increases is often attractive. While most insurers do not offer immediate annuities with cost of living increases tied to some index such as the consumer price index, some do, and more are likely to be offering such contracts in the future in response to a demand that appears to be increasing. An additional attraction is that annuities enjoy creditor protection in most jurisdictions.
A disadvantage to immediate annuities, in this context and others, is their inflexibility. Most immediate annuities, once begun, do not permit modification of the payment amount or commutation, although an increasing number of contracts do.
Read on for 10 situations where an annuity can be the ideal estate planning tool.
1. Purchase of an immediate annuity for heirs outside a trust
Sometimes, an estate owner’s goals include providing a specific and certain income for specified heirs, apart from the overall dispositive provisions of the estate plan. Here, an immediate annuity is arguably the perfect instrument. Without the certainty of the annuity, a trustee or executor must take into account the market risk involved when invested assets must be accessed each year to make payments to the beneficiary. Thus, the use of an annuity may allow the trustee/executor to invest more money immediately on behalf of the other beneficiaries while still guaranteeing that the income beneficiary will receive all promised payments.
2. Purchase of a deferred annuity for heirs
Where estate planning goals include providing a certain income for heirs to begin at some future time, a deferred annuity may make sense. Advantages include tax deferral of current gains, which can be of considerable importance if the annuity is owned by a trust subject to the compressed tax rates applicable to nongrantor trusts, creditor protection (to the extent allowed by relevant law) where the annuity is owned outside a trust, and the risk management and investment characteristics of deferred annuities discussed at length in earlier chapters of this book. Disadvantages include the overhead cost of the annuity, which may be higher than that of alternative investments, surrender charges (if applicable), the fact that all distributions from an annuity are taxed at ordinary income rates, and the unavailability of a step-up in basis for annuities owned by a decedent.
3. Purchase of a SPIA by the estate owner for the estate owner and spouse
Impact on the attractiveness of making lifetime gifts to heirs
A primary goal of many, if not all, estate owners is to ensure income for themselves for their lifetimes. This goal often surfaces in discussions between clients and advisors when considering lifetime gifts. “I might need that money” is perhaps the most common objection raised by many clients to suggestions that they utilize the gift tax annual exclusion in making lifetime gifts to heirs. To the extent that the estate owner is guaranteed that he or she — and his/her spouse, if applicable — can be assured of required income no matter what, annual gifts to heirs, whatever the reason for making them, may be far less worrisome.
If, having secured this required income, perhaps by purchasing an immediate annuity, a client feels able to make more lifetime gifts than he or she otherwise would, the result can be both greater net wealth transferred to heirs — due to lower transfer tax and estate clearance costs — and greater emotional satisfaction. One can live to see his heirs enjoy lifetime gifts. One can also see how well such gifts are managed. For the parent or grandparent concerned that sizeable inheritances might spoil the kids, being able to see how well those kids deal with the money can be both gratifying and informing. If the kids mishandle such gifts, estate plans can be changed, perhaps by adding additional spendthrift provisions.
Implications for the estate owner’s asset allocation decisions
Even where lifetime gifts are not a concern, adequate income for the estate owner(s) is usually a key estate planning goal. “We want to provide for the kids and grandkids, but first we’ve got to take care of ourselves” is a refrain familiar to all estate planners. Allocating a portion of one’s retirement portfolio to an instrument designed specifically to produce income can help one achieve this key planning objective, to the extent of making the allocation of remaining assets easier, or at least, less worrisome. This can be done using either a deferred annuity or an immediate annuity.
4. Using the guarantees in a deferred annuity to provide portfolio insurance
A fixed deferred annuity provides three guarantees to its owner:
- A guarantee of principal. The money invested in a fixed deferred annuity is guaranteed against loss by the insurer.
- A guaranteed minimum rate of return.
- Guaranteed annuity payout factors.
The first two guarantees provide a known minimum return, on the portion of one’s portfolio allocated to the annuity, which has the effect of lowering the overall principal and interest rate risks of the entire portfolio. Moreover, the assurance that this known future value can be converted into an income stream that will provide at least a certain amount of money each year can make projections of one’s future cash flows less problematic.
A variable deferred annuity does not offer the first two guarantees to the living policy owner, except to the extent that annuity values are invested in the fixed account. However, it provides others. The guaranteed death benefit always provides assurance that heirs — not the living policy owner — will receive, at a minimum, the amount originally invested or the account balance at death, if greater. Enhanced death benefit guarantees, common in newer variable contracts, can assure heirs of the greater of that original investment or account balance at death or some other potentially higher minimum amount; perhaps the account balance at some policy anniversary prior to death or the original investment, compounded at some specified rate of return. If the minimum amount that will pass to heirs is a serious estate planning concern, the guaranteed death benefit may be worth its cost.
The guaranteed living benefits in today’s variable deferred annuities may provide even more comfort for the estate owner in making his asset allocation decisions, precisely because of the refrain noted earlier, namely: “We want to provide for the kids and grandkids, but first we’ve got to take care of ourselves.” The guaranteed minimum income benefit, guaranteed minimum withdrawal benefit, guaranteed minimum accumulation benefit, and provisions combining all three features can assure the estate owner that, irrespective of the performance of the investments in the annuity, certain minimum income and/or future lump sum values will be available.
See also: What do annuity buyers want?
Many critics contend that the costs for these provisions outweigh the benefits that they are likely to provide. The mathematics supporting such a conclusion — if any are supplied — often rely upon historical averages and probable life expectancies. This is not to say that all such criticisms are invalid, or that the logic and mathematics are never valid or persuasive. They may be both. However, it is the authors’ contention that the certainties these riders provide can be very important to many estate owner clients on an emotional level. These certainties, with regard to that part of a client’s portfolio invested in annuities providing them, can enable the client to make asset allocations with regard to money that the client might not otherwise feel comfortable making. In addition, it’s important to note that even though the client may come out with less money in the long run on average, the client is still guaranteeing that a particular minimum amount will be available, which may be more consistent with a client’s goals than merely having the most dollars at death by investing heavily in equities.
Many clients, especially older ones, are often wary of putting too much in the stock market, even though they know that equities have historically provided significantly better returns than fixed dollar investments such as CDs and bonds. To the extent that such a conservative (read: risk-intolerant) client’s equity investments can be held in an investment account which guarantees minimum future lump sum and present and future income values, the client may be willing to allocate more of his portfolio to such equities, and remain invested in them longer than if no such guarantees were available. For the client whose portfolio is not large enough to generate required income with reasonable certainty if invested very conservatively, this increased equity exposure might make the difference between an adequate income and just getting by, or even running out of money. Why might this be? The client might only be willing to invest substantially in equities if there are underlying guarantees, and would otherwise choose a much more conservative portfolio, with lower expected risk and return.
5. Using the guaranteed income of an immediate annuity to reduce retirement portfolio failure rate
As noted, the risk management benefits of either a fixed or variable deferred annuity may allow some clients to invest their retirement portfolios — the portion invested in those annuities, but also, perhaps, more of the nonannuity portion — more aggressively, and with more confidence, than they might in the absence of these guarantees. The result of such a change in allocation should, over time, be an increase in the income produced, despite the expenses of the annuity. For retirees living on less than the amount their portfolios earn, this translates to greater capital accumulation, ultimately providing more wealth to transfer to heirs.
Yet many retirees do not live on less than what their investments earn. For all too many clients, the most important issue is not how much will be left to heirs after they die, but whether their portfolios will produce enough for them to live on, for as long as they live. Indeed, this uncertainty represents what one of the authors refers to as the one big risk in retirement income planning, namely: “What are the chances that my account balance will fall to zero before my blood pressure does?” This risk can be managed, with considerable effectiveness, by use of immediate annuities. As was noted in the last chapter, there is mounting evidence that allocating a portion of one’s retirement portfolio to a mechanism providing immediate, certain income can produce a significant increase in the probability that the portfolio as a whole will be able to provide required income for the retiree’s entire lifetime, however long that may be.
The purchase of a life annuity, either for a level or an increasing annual benefit, can offset — to an extent proportional to the percentage of required retirement income provided by the annuity — the effects of negative dollar cost averaging, where more shares must be liquidated to provide a set amount of income after a decline in the value of those shares than would have had to be sold if the share price remained level or increased. A life annuity is not the only way to implement this strategy. Laddered bonds or laddered period certain annuities may also be used. Whatever the implementation, this strategy can offset negative dollar cost averaging, decrease the probability that the retirement portfolio will be exhausted during retiree’s lifetime — or produce declining income levels — and provide greater emotional comfort, although only an annuity guarantees that payments will continue even if an individual lives much longer than anticipated. In addition, this strategy may foster greater willingness to make lifetime gifts to heirs and/or gifts — lifetime, testamentary, or both — to charities.
6. Using annuities to maintain tax deferral, and control, from beyond the grave
Ensuring tax deferral of gain beyond the annuity owner’s lifetime
The income tax on annual gain in a deferred annuity is generally deferred until it is distributed. Distributees of annuity proceeds can benefit from even further tax deferral if those distributions are considered amounts received as an annuity. If so, a portion of each payment is excluded from tax as a return of principal under the regular annuity rules of IRC Section 72(b). This treatment applies to annuity payments whether made to an annuitant or to a beneficiary. Thus, if a deferred annuity is structured so as to ensure that the beneficiary or beneficiaries can, or perhaps must, take proceeds in the form of an annuity, the benefits of tax deferral will survive the annuity owner. This can be done utilizing a concept known as the stretch annuity.
What is a stretch annuity? In its broadest sense, one might say the term describes any annuity where the beneficiary designation allows, or requires the beneficiary to stretch death proceeds, and the benefits of tax deferral of undistributed gain, over as long a period as possible. Deferred annuity contracts nearly always allow the beneficiary to take proceeds in the form of an annuity, either over lifetime or for a period of years. If the beneficiary is the surviving spouse of the owner, he or she is typically granted a spousal continuation option, allowing an election to treat the contract as if it were his/her own from inception, and to name new beneficiary(ies), who will, themselves, be able to choose to take proceeds as an annuity. Moreover, many contacts permit the owner to ensure that death proceeds will be eligible for the favorable tax treatment of the regular annuity rules by allowing the owner to require that death proceeds be taken by the beneficiary(ies) as an annuity. This election is usually made on the beneficiary designation form, or by election of a special contract option. Such election is usually revocable by the contract owner at any point before death, but not by the beneficiary after the owner dies.
However, election of a regular annuity payout option, whether by the owner or beneficiary, is not necessarily the only way to achieve this post-death tax deferral. The IRS has privately ruled that payment of annuity death benefits to a beneficiary where the amount of each payment is determined by the life expectancy fraction method, rather than by the payout factors of a regular annuity option, can satisfy the requirements of IRC Section 72(s). The undistributed gain would not be constructively received (and would, therefore, enjoy tax deferral until it is distributed). In other words, the private ruling allowed a beneficiary to take systematic withdrawals as the beneficiary of an annuity, without annuitizing, and still stretch the payments — and tax on the gain — over the beneficiary’s lifetime.
7. Using a SPIA to provide for a longtime household employee
Often, wealthy clients wish to provide benefits, at their deaths, to longtime household help. They may be concerned that the employee might lack the skills to manage a lump sum bequest, or might squander it. A direction, in the estate planning documents, to purchase an immediate annuity for the benefit of that employee can address these concerns, without the hassle of establishing a standalone subtrust for such purposes. A SPIA would ensure an income for that employee for lifetime; moreover, the cost of a life-contingent immediate annuity for a specified amount of income decreases with the age of the annuitant at issue. Thus, the longer the estate owner lives, the older the employee will be when the annuity is purchased, and the lower the cost of the annuity.
8. Using a SPIA to fund a small bequest
Similarly, a SPIA might be used to fund a small bequest to someone not a beneficiary under the client’s trusts, where there is concern that the recipient might be unable or unwilling to manage the bequest prudently and where the amount of the bequest is less than the minimum that professional trust managers will accept. Of course, this assumes that the SPIA bequest itself would still produce a large enough monthly or annual payment to be a meaningful bequest in the eyes of the decedent.
9. Purchase of a SPIA by a trust for the benefit of children not his and hers
As Mancini, Olsen, & Warshaw note, “When a trust is created at the death of an individual for the benefit of his or her spouse and children, if the children are not also the surviving spouse’s children, tension can develop over the trust’s investments.” One solution might be for the trustee to be directed to purchase one or more immediate annuities for the benefit of that deceased spouse’s children and manage the balance for the benefit of the other trust beneficiaries. Of course, this does separate out the trust principal at the time of first death, making such principal, and its interest, unavailable to the surviving spouse while he/she is still alive, but it avoids the cost of drafting multiple trusts to accommodate all the heirs.
10. Using a deferred annuity to fund a QTIP trust
In some estate planning situations involving trusts, the use of an annuity may be problematic. Gary Underwood writes:
“Annuities may not be appropriate investments for QTIP trusts for a reason associated with state law definitions of income. In most states, the undistributed gains inside of an annuity are not defined as income, and therefore may not have to be distributed to the income beneficiary. Income would only be recognized to the extent the trustee made withdrawals of gains from the annuity. If the trustee made no withdrawals, then there may be significantly less trust income to distribute to the surviving spouse. The trustee could be placed in an unenviable position between the surviving spouse who may want to maximize income and the children who want to maximize principal for later distribution. Unless the trustee and all beneficiaries agree on specific parameters for any annuity withdrawals, an annuity may present problems.”
Some of the aforementioned problems highlighted by Underwood can be mitigated by a clear drafting of the QTIP trust before the first death (i.e., to clearly state what constitutes income and whether/how income with respect to the annuity will be classified for income distribution purposes). In some cases, the treatment of an annuity may be preferable to alternatives, if the specific goal is actually to minimize income distributions to the surviving spouse. On the other hand, if the spouse is not happy with such an arrangement, the spouse could potentially have the annuity liquidated, under the required right of a spouse under a QTIP trust, compeling the trustee to convert QTIP assets to income-producing property. If such a conversion occurs after many years, the trust could be compelled to recognize significant accrued taxable gains in a single year. Accordingly, it may ultimately be wise to avoid the use of deferred annuities inside of a QTIP trust, unless the spouse income beneficiary is clearly supportive of the arrangement, and unlikely to have his/her mind changed.