What kind of annuity designs make sense, especially in the variable annuity world, in view of the new Pension Protection Act of 2006?
As readers will recall, the PPA grants suitably designed long term care contracts sold within annuities the same favorable tax treatment accorded to LTC insurance contracts sold on a stand-alone basis.
Some key tax act considerations will help focus on the annuity opportunities.
One favorable treatment under the PPA is that annuity values used to pay for charges for qualified long term care insurance (Q-LTC insurance) are not taxable.
This enables gains in an annuity to escape, legitimately, income taxation under certain circumstances. If a consumer is funding a stand-alone contract, the person is likely to be explicitly or implicitly earning some interest income on the assets used to fund the contract. The tax has to be paid. By comparison, annuities with Q-LTC insurance features have an advantage over the stand-alone situation. This is due to the tax treatment under PPA, as noted above.
The Q-LTC insurance benefit payments are just as income-tax-free as those from a qualified stand-alone contract.
The framers of PPA didn’t just grant these advantages at no cost. We know that the annuity combination will have higher deferred acquisition costs than an annuity without attached LTC insurance. (This applies only to 2010 and later.)
Thus, the critical question is this: Can favorable annuity and Q-LTC insurance designs be built that take advantage of the favorable tax treatment?
The answer is yes, provided that the added Q-LTC benefit is meaningful in terms of its value to the customer. If it is not meaningful, the astute customer and certainly the astute account representative will see the annuity’s higher cost and question whether a minimalist LTC design is worth the money.
Concerning the annuity component, 2 critical designs have largely spearheaded the success of variable annuities in recent years: the guaranteed minimum income benefit (GMIB) and the guaranteed minimum withdrawal benefit (GMWB.)
With a GMIB, the individual will, regardless of investment performance, be able under certain conditions to annuitize a benefit base of some substance and receive payments for life. The first point at which that can happen is usually several years after policy issue (10 years is common).
It is quite possible that favorable performance will lead to an attractive annuitization option in its own right, in which case the current annuitization rules would apply.
How can LTC be reflected in the GMIB design? Many options are possible. The basic idea is either: 1) to enhance the amounts being annuitized in case of earlier onset of chronic illness or 2) to increase the actual payments at time of chronic illness onset, should that occur after payments have begun. Because the goal is to make the payments tax-free, the design must be structured with extreme care; of course, the outcome would be worth it.
With a GMWB, the individual will, regardless of investment performance, be able under certain conditions to receive a string of stipulated payments. As with the GMIB, these payments would also be based on the benefit base concept, would be paid out for life and could be enhanced on account of chronic illness. The key is to maximize fully the amount of the income- tax-free payment.
Many other factors come into play, such as underwriting (the famous “kiss” principle applies), per diem or reimbursement, administrative issues and financial issues (e.g., the impact of LTC inclusion on contract persistency).
The important point is that the design must be built with care. That said, building an annuity that helps the buyer address accumulation, payout and LTC protection concerns all in one contract is well worth the investment.