VA Income Options Going Next-Gen

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Traditional annuitization from variable annuities used to be the only way for advisors to offer clients lifetime retirement income. This is changing as the industry starts to release next-generation options.

First, some background. Traditional VA annuitization has provided a less than ideal income solution. For instance, it seems to require clients to relinquish asset control to the insurance company at annuitization. Likewise, brokers who facilitate the annuitization effectively lose those assets under management. Additionally, in most cases, traditional VAs do not offer any mechanism to help the payouts keep pace with inflation, as the annuitization typically occurs on a fixed basis.

In response to these evident drawbacks, VA companies have developed the guaranteed minimum withdrawal benefit for their VAs. The GMWB provides an income stream that generally doesnt require clients to give up asset control.

Now, some insurers are expanding this approach. To help retirees plan for the retirement income they will need, the companies are offering lifetime withdrawals on the GMWB features in their VAs. This “lifetime GMWB” offers 3 key features:

1) Allows clients to maintain equity exposure and maximize potential for growth while providing a hedge against inflation;

2) Enables clients to retain control and access to the asset once income is being drawn;

3) Mitigates longevity risks by guaranteeing the lifetime income stream.

The lifetime GMWB does have some drawbacks relative to variable annuitization. For instance, the features typically dont reflect age in the income payment. Receiving a 5% lifetime income may look attractive to a 55-year-old, but a 60- or 70-year-old client may be leaving some income on the table if the client takes the GMWB (which is not age-related) rather than annuitizing (which does take client age into consideration).

The protection offered by the lifetime GMWB guarantees enables VA clientsfor the first timeto keep their money in the market by helping shield the assets from the negative effects of market downturns. This means the assets can have more power to outpace inflation. And, unlike previous forms of annuitization, these lifetime income streams dont require clients to give up control of the assets to an insurer.

Recently, however, a new concept has emerged that combines elements of both of these retirement income options. The feature is being called a “next generation lifetime income” method of annuitization.

The next-generation method can have substantial tax advantages over the other arrangements, especially when using annuities in nonqualified retirement plans.

Next-generation annuitization addresses the shortcomings of both GMWBs and traditional annuitization. What makes it advantageous is that it retains the tax advantages afforded to the traditional annuity (which GMWBs do not) while keeping the control, access and flexibility of the GMWBs.

Table 1 summarizes the features and benefits each option provides. Table 2 compares a sample next-generation annuitization model with a typical 5% GMWB model for a male client with $100,000 to invest. The chart shows the amount each product type affords the client for actual retirement income after taxes have taken their cut.

What Table 2 shows is the negative impact that systematic withdrawal can have on spendable income from a nonqualified VA due to being taxed on a gain-first basis. For instance, the 60-year-old client with $100,000 to invest could take out $5,000 for life with most lifetime GMWBs, guaranteed. However, because this is taxed gain-first, a substantial portion is lost to taxes. Assuming a 30% tax rate and even a modest 5% return, the client only receives $3,500 after tax.

A client using variable annuitization with a floor benefit has a slightly different scenario. His/her guarantee typically will be less (in this instance, the lifetime income guarantee is $4,246 vs. the $5,000 for the GMWB). However, the initial income is actually higher ($5,662) due to receiving a portion of cost basis back. Of the $5,662 income payment, $3,667 is considered tax-free due to return of cost basis. This means the client is only taxed on $1,985, providing him/her with a substantially higher spendable income of $5,066.

In all four of the ages above, the tax-free portion of the income exceeds the GMWBs after-tax total income, assuming a 30% tax rate and 5% return. Essentially, even with a lower guarantee and modest market, the annuitization with access to account value provides more spendable incomein this case significantly more income.

The client will continue to receive this tax-free return of cost basis until he or she gets 100% of the original cost basis back (for the 60-year-old above that would be about 27 years!). Keep in mind, taxes may be due upon distribution. Guarantees are backed by the insurers financial strength.

Under next-generation annuitization, asset control remains with the client; brokers continue to retain assets under management; and income payments for life can be guaranteed at a minimum income level, regardless of market activity even with substantial equity exposure. The rate of income is protected from not only market downturns but also against the bite of inflation. Most importantly for clients, there are tax advantages, meaning they can keep more of their money where it belongs.

Given the bear market of a few years ago, a lot of financial focus is now on guarantees. This is good, in that guarantees can allow VA clients to stay invested knowing they are protected against a downturn. However, with the market rebound of the last 2 years and the plethora of guarantees now available, clients need to have ways to keep taxes in check, too. Guarantees are a critical component, but it is important that the right guarantees be applied to capture clients goals and maximize after-tax returns, particularly in nonqualified accounts.

Del Campbell is assistant vice president-annuity product intelligence and Jamie Branyan is marketing intelligence consultant with Lincoln National Life Insurance Company, an affiliate of Lincoln Financial Group.


Reproduced from National Underwriter Edition, April 1, 2005. Copyright 2005 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.