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Financial Planning > Tax Planning

Annuity Analytics: Back to Basics

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In my recent travels through the world of retirement income planning, it seems to me that many industry participants have forgotten two important facts about the current economic environment.

First, a substantial demographic segment of the U.S. population is still very much in accumulation mode and quite far from retirement income needs, especially after last year’s stock market setback.

Second, as the U.S. emerges from the Great Recession, a $1.6 trillion (and growing) deficit will eventually have to be financed with higher income taxes. In other words, given the proportion of the population still accumulating funds for retirement and the likelihood of increased tax burdens on the middle and upper class, I think the economic value of tax deferral is being overlooked by many annuity manufacturers, marketers and distributors.

Accordingly, in this column I would like to go “back to basics” and examine the technical benefits of pure tax deferral in the accumulation phase of retirement planning, independently of the guarantees and lifetime benefits applicable in the income stage.

There are obviously many ways — and assumptions you can make — to analyze the tax benefits (or costs) of annuities. My preferred approach is to start by making the smallest number of assumptions and keep things as easy as possible for as long as possible to develop a strong intuition. Indeed, when explaining this to individual clients, the motto should be: simplicity first, then accuracy.

So, here’s my starting point: Assume that you invest $100 in a generic “portfolio” and you plan to hold this investment for a long time. The core investment can be a mutual fund, sub-account, managed account, ETF, etc, which sits inside a particular tax structure.

The table on the following page illustrates the consumable value of this investment under three generic income tax structures. The three are (#1) no-tax-ever, (#2) higher-rate, but tax-deferred, and (#3) lower-rate, continuously-taxed.

Think of the first as a (universal) life insurance policy in which the death benefit is tax-free, the second is an annuity in which gains are tax deferred but then taxed at the ordinary income rate upon (live) withdrawal, and the third is a taxable account in which capital gains are taxed on an annual basis. Yes, I am playing a bit loose here, but bear with me. Remember, simplicity first.

Finally, for the actual numbers, assume that (federal) taxes on ordinary income is 35 percent, and (federal) taxes on capital gains is 20 percent, which is a conservative forecast of where the current (historically low) 15 percent rate is soon headed. I’ll ignore state and local taxes, to keep things simple. (Or, assume you live in my favorite states, Texas or Wyoming.)

Here’s how to read and interpret the table. The second, third and fourth columns display after-tax (consumable) values for your $100 initial investment under the three structures, assuming the underlying portfolio earns 7.29 percent after-fees pre-tax each year. (Later I’ll explain why I selected a return of exactly 7.29 percent, but for now think of it as the long-term after-fee return from a generically diversified portfolio.)

And here’s how the three structures play out:

o In the no-tax-ever structure, the entire gain escapes taxation. So, the pre-tax value and the after-tax value are equal at every point along the investing time horizon. In 10 years, your initial $100 investment grows to approximately $202, and after 30 years it grows to $826. This is easily verified by multiplying $100 times the (1.0729) return factor (my 7.29% return) to the power of the number of years. Generally speaking, it can be expressed algebraically as (1+R)^N, where N is the number of years and R is the investment return.

o In the high-rate, tax-deferred structure, your gains are tax-deferred while the money is invested, but once you cash in or withdraw the funds you pay (relatively high) income taxes on all gains at the rate of 35 percent. This leads to after-tax account values of approximately $166 in year 10 and $572 in year 30. The algebra is: (1-Tx)(1+R)^N+Tx, where Tx is now the 35 percent tax rate.

o Finally, in the low-rate, continuous-tax structure, you pay incremental taxes on all investment gains as they occur, but at a relatively low rate of 20 percent. In this scenario, when you eventually withdraw the funds, no additional income taxes are due. The value of your portfolio in year 10 is approximately $176 and it is $548 in year 30. The algebra needed to generate these numbers is: (1+R(1-Tx))^N, where Tx is now the 20 percent rate on capital gains.

Compare the after-tax results under the three structures at different points in time. Obviously, the no-tax-ever structure leads to the highest portfolio value, always. The gap between the no-tax-ever and the other two structures grows rapidly as the holding period lengthens, and you can clearly see the drag (pun intended) created by taxes.

The final column displays the tax avoidance benefit, which is almost 50 percent after 35 years. But given that “no tax ever” isn’t a realistic investment plan (since you have to die), which of the remaining scenarios is preferable — and when?

As shown in the table, in the (#2) tax-deferred structure, the portfolio value is lower compared to the third (continuously-taxable) scenario for the first 25 years — but the disadvantage disappears in year 25. In year 25 the after-tax value of the portfolio under both structures is identical. After that 25-year milestone, the tax-deferred account structure dominates. (That is, structure No. 3 prevails until year 25, and No. 2 prevails thereafter.)

These numbers — and specifically the 7.29 percent annual return — were manufactured to create the year 25 “switchover” between the two options, but the underlying rationale, and the general result holds under any combination of tax rates and investment returns.

Following on the underlying logic, a basic tax-deferred annuity that treats all withdrawals as ordinary income makes little sense when the investing horizon is short. For these terms, if you can structure your investment such that you pay (only) 20 percent on your gains along the way, this is better than paying 35 percent on all gains when you withdraw. The lower your capital gains rate, explicitly or implicitly via tax-efficient loss realization strategies, the greater the benefit of not using the annuity.

However, once the investing time horizon is longer, the situation is reversed. For a longer horizon, it makes sense to incur the high 35 percent tax rate at withdrawal in exchange for the benefit of tax deferral along the way. The particular break-even point will depend on your return and tax projections. You can go to for a quick calculator to compute the break-even point for any combination of time horizons, tax structures and tax rates.

Likewise, if the projected long-term investment return is higher (than 7.29 percent) the breakeven date is earlier than year 25. And, if the projected investment return is lower — for example because of higher fees — the breakeven date is later, and perhaps even infinity (i.e., never.) Finally, if you can lower the effective tax rate upon withdrawal (from 35 percent) by annuitizing, the breakeven date can be much earlier.

Understanding what economists call the comparative statics is essential for motivating the tax deferral benefit and the role of “accumulation” annuities, independently of everything and anything else that is being included in the package.

So, as the financial services industry continues to restructure in a world of great turmoil and uncertainty, perhaps the “accumulation” annuity will return to its roots as a proverbial tax shelter from the coming fiscal storms.

Moshe A. Milevsky, Ph.D,. is an associate professor of finance at York University in Toronto, and Executive Director of the non-profit IFID Centre at the Fields Institute for Research in Mathematical Sciences. His next book entitled: Your Money Milestones: A Guide to Making the 9 Most Important Financial Decisions in Your Life, will be published by FT/Pearson in December 2009.


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