Annuities Are Good For Tax-Qualified Retirement Plans

By Norse N. Blazzard and Judith A. Hasenauer

A considerable amount of controversy, and even some litigation, has arisen in the past few years about whether annuities–particularly variable annuities–are appropriate for use in qualified retirement plans.

The plaintiffs lawyers who have brought litigation on this issue have used the justification that placing a VA inside a qualified retirement plan is redundant and unnecessary. Their argument is this effectively results in the placing of a “tax-shelter within a tax-shelter.”

Since the VA has costs associated with it, the reasoning these people use against the inclusion of a VA within a qualified retirement plan is that it is an unnecessary additional cost for the tax-deferral advantages already afforded by the qualified retirement plan.

This reasoning fails to recognize the true purpose of an annuity. This purpose is not to obtain tax deferral. Rather, it is to guarantee income that cannot be outlived. It is an insurance policy–not insurance against dying too soon, but insurance against living too long.

This lack of understanding about the VAs true nature is what gives rise to the confusion about the charges that are incorporated into the product. This is also what has spawned litigation over the use of VAs in qualified plans.

As an interesting historical note, probably the largest block of VAs in existence has been with a form of qualified retirement plan called the tax-sheltered annuity (TSA). This form has been available to employees of public schools since 1962 in accordance with Section 403(b) of the Internal Revenue Code.

The people who question the use of annuities with qualified plans should research the fact that, until 1974, the only product the government permitted to be used with the TSA was an annuity contract issued by a legal reserve life insurance company.

Indeed, until 1968, all VAs issued in this country were issued exclusively to qualified retirement plans. It was not until 1968 that the first VA was issued outside of such a qualified retirement plan. Moreover, it was not until the early 1980s that the use of VAs with nonqualified retirement plans became widely accepted.

In 1974, the Employee Retirement Income Security Act permitted, for the first time, products other than annuity contracts to be used with TSAs. At that time, custodial accounts utilizing mutual funds were also permitted to fund TSAs.

The confusion over the basic nature of a VA has added to the lack of understanding about why the product is appropriate for use with qualified retirement plans.

Many of the popular and financial news media have mischaracterized the elements of a VA. Much of this confusion no doubt relates to some of the ancillary benefits commonly included in VAs.

For instance, the minimum death benefit, which has been part of VAs almost from the beginning, is the most frequently confused product feature.

Originally, the minimum death benefit merely guaranteed a return of principal in the event the contract owner died when his or her contract value was lower than the original premium. As the years passed, insurers began offering enhanced minimum death benefits that had the ability to provide not only return of principal, but also some element of investment gain.

Unfortunately, the media (and even some sales people) have confused the annuity guarantees inherent in annuity contracts with these minimum death benefit features.

Any commercial annuity contract, whether fixed or variable, guarantees the annuitant that he or she will not outlive the funds available under the contract. This is the basic and primary insurance feature of an annuity.

It is for this guarantee that the so-called “mortality” charge is made against VAs. It is for assuming the annuity risk under the contract–i.e., to compensate the insurer against the risk that too many annuitants will live too long and that the reserves established will not be adequate to fund the future annuity payments. In such an event, the insurer must make up the difference from its capital and surplus.

Any charge for the minimum death benefit has usually been separately stated or has been merely incidental to the mortality and expense charges specified in the VA.

VAs should not be sold merely to afford their purchasers with income tax deferral. VAs (and all annuities) should be sold to provide for lifetime income.

Tax deferral may certainly be one of the motivations for people to purchase annuities. However, the tax advantages afforded to annuities under the Internal Revenue Code were not intended to be a windfall to the life insurance industry. They were intended by Congress to give citizens an incentive to provide for their own lifetime income.

Remember, for many years Congress required an annuity contract issued by a legal reserve life insurance to be the only product that could be used with qualified TSA programs.

That fact clearly shows that the annuity insurance element was an important tax policy consideration in the program. We do not believe that either plaintiffs lawyers or the courts should second-guess the congressional policy decisions in this matter.

People are given the opportunity to participate in tax-qualified retirement plans to enable them to enjoy their retirement years free from financial worries. What is more basic to the provision of retirement security than income that cannot be outlived?

We are constantly being warned that increasing longevity among our aging population will strain our public and private retirement systems. It would therefore seem to be sound basic policy to continue to encourage people to use their primary retirement funds to purchase income that cannot be outlived. The only commercial vehicle that affords such a guarantee is a life contingency annuity offered by a legal reserve life insurer.

If legal action or confusion by the media results in the inability or reluctance of people to use their qualified retirement funds in connection with annuities that can guarantee income regardless of longevity, then this will result in a grave injustice.

Moreover, we may see large numbers of our aged people who have outlived their retirement funds, reliant on charity or family, or forced back into the workplace in order to survive.

Our government has clearly indicated that there is strong public policy to encourage people to provide for retirement income they cannot outlive. Common sense would agree with this policy.

All elements of the annuity industry should unite to resist any attempts to constrain the use of annuities with qualified retirement plans.

Norse N. Blazzard, JD, CLU, and Judith A. Hasenauer, JD, CLU, are attorneys in the Ft. Lauderdale, Fla., office of Blazzard, Grodd & Hasenauer, P.C. Their e-mail is: Norse.Blazzard@bghpc.com.


Reproduced from National Underwriter Edition, April 7, 2003. Copyright 2003 by The National Underwriter Company in the serial publication. All rights reserved. Copyright in this article as an independent work may be held by the author.