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Income planning outlook for 2010: Prudence now rules

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“Many of the success stories we enjoyed in 2009 revolved around income guarantees, especially riders on variable annuities that allow clients to capture market gains while also providing a floor when equities turn south,” says Benjamin Hill. “Although VA investment subaccounts were negatively impacted by the markets this past year, clients’ incomes did not diminish–in some cases they even rose–because of the product guarantees.”

Hill, a financial planner and principal of Hill Financial Advisors, Westlake Village, Calif., says that VAs offering guaranteed minimum income and withdrawal benefits will maintain a prominent place in income planning strategies in 2010. Because individual retirement accounts suffered such severe losses during the economic downturn, clients increasingly are turning to vehicles that can withstand, and benefit from, market fluctuations.

The VA guarantees give clients the confidence to invest more aggressively than they would otherwise feel comfortable doing in a down economy, he adds.

How much longer VA manufacturers can make good on these guarantees remains, an open question, however. As insurers’ own investment portfolios also got wacked during the recession, they now have to shore up their capital reserves. To that end, sources says, some carriers are instituting less attractive guarantees, dropping them, or raising fees for the optional riders.

Says Hill: “This past year, a number of insurers reduced their guarantees on products and increased expenses. It’s amazing how quickly they’ve changed prices and features to adjust to the current economic realities.”

John Henry McDonald, a chartered financial consultant and founder of Austin Asset Management Co, Austin, Tex., agrees, adding: “The poor investment performance of the life insurers will likely affect annuity payouts. The low portfolio returns have already resulted in higher premiums on term insurance.”

The financial troubles of carriers have not gone unnoticed by advisors. As financial institutions with once sterling reputations teetered on the brink of collapse, sources say, inquiries about the financial strength of life insurers have taken on added importance in client engagements.

The heighted caution is reflected in advisors’ product and plan recommendations. “Prudence now rules,” says Bruce Brittain, a principal at Brittain Financial Advisors, Highland, Utah. “Anything that might appear to be too aggressive I’ve removed from client conversations. In light of what’s happened to the economy, I’ve had to rethink everything I say and do in my practice.”

Products aside, what might put a damper on clients’ income plans would be more burdensome taxes, experts say. Advisors remain concerned, for example, about a possible reversion to the pre-2001 estate tax regime.

Under the Economic Growth and Tax Relief Reconciliation Act (EGTRRA) of 2001, the estate tax exemption and top tax rate, respectively $3.5 million per individual and 45%, are due to sunset for one year in 2010. If Congress does nothing–the U.S. House of Representatives voted on December 3rd to make the 2009 tax provisions permanent, but the Senate has yet to take action–the estate tax will revert in 2011 to the pre-2001 regime, capping the individual exemption at $1 million and the top tax rate at 55%.

Should Congress act to return to the pre-2001 framework even sooner, experts say, clients who until now were safely within the exemption limits would suddenly find themselves with an estate tax problem. That, in turn, could adversely impact retirement assets needed to fund income plans.

“If we go back to a $1 million exemption, then people with a $3 million portfolio and $5 million in net worth will have a huge tax issue,” says McDonald. “Assets that otherwise would be devoted to retirement could be eaten up funding a life insurance policy to pay the tax. For individuals in their 60s or 70s, particularly those with health problems, the premiums could be substantial.”

Life insurance might also come into play if, as observers expect, holders of traditional individual retirement accounts convert them to Roth IRAs next year. A $70 billion tax cut provision enacted in May of 2006 allows taxpayers with modified adjusted gross incomes of more than $100,000 to convert to a Roth IRA in 2010 and spread the income tax due on the transaction over the subsequent two years.

For producers, sources say, the tax law change could yield additional life insurance sales, as clients undertaking conversions buy or upgrade policies needed to replace retirement assets paid to cover income tax on a conversion. The policies can also provide liquidity to Roth IRA beneficiaries who may have to pay estate tax.

“We expect Roth IRA conversions to be a hot topic in 2010, as it will open up opportunities for a large number of potential clients,” says Matt Rowles, advanced marketing director-individual life insurance, at Prudential Financial, Newark, N.J. “By covering the tax bite with a life insurance death benefit, policy beneficiaries can secure the full value of the IRA.”

Clients have potentially another incentive for doing a Roth conversion: the prospect of higher income tax rates, These are expected since the federal government will need additional revenue to pay down the mounting federal budget deficit and national debt, sources say. Clients who elect now to pay income tax on the conversion will thus be in a more advantageous position than those who wait and convert under a more onerous tax regime.

“If you convert a $1 million IRA to a Roth IRA, then you’re paying a lot of income tax–$350,000, at the current 35% tax rate,” says McDonald. “But clients may be looking at 70% in the future. We’re telling clients to act now on anything that may be tax-favorable.”

Given a likely rise in income tax rates, McDonald adds, purchasing a deferred annuity may not make sense in all cases, as income taxes paid on required minimum distributions (RMDs) could also be subject to high tax brackets. Where appropriate, he says, clients should keep a portion of their portfolios in assets subject to capital gains tax.

Long-term capital gains, which apply to assets held for more than one year, are currently taxed at a 15% for individuals occupying the 15%-35% tax brackets; those subject to the two lowest income tax brackets (10% and 15%) pay zero capital gains tax. Enacted in 2003, these capital gains rates are effective through 2010.

In part because of comparatively low capital gains rates, says Hill, he frequently recommends using charitable remainder trusts as part of an income planning strategy. The CRT–a vehicle that provides an annuity-like income stream to the trust grantor while alive and a remainder interest to the grantor’s charitable beneficiary at death–imposes a long-term capital gain tax on income paid by out by the trust.

That could turn out to be a very good deal. To illustrate, Hill observes that an apartment complex valued at $1 million and yielding 7% in gross rental income might net only 3% ($30,000) annually for the owner after factoring in maintenance, property taxes and income tax. Should, however, the client deed the complex to a CRT (the trustee of which would sell the real estate asset in exchange for a diversified investment portfolio), the client can double the net payout, thanks in part to the lower capital gains tax (federal and state). And because the CRT sold the asset, maintenance costs and property taxes also are avoided.

Ultimately, observes Hill, revisions to tax laws must be considered when determining which retirement plan assets should be drawn down to meet income needs. “The income mix would change depending on the tax treatment of distributions,” he says.

What else should clients weigh when deciding on an income planning strategy for 2010? David H. Diesslin, principal of Diesslin & Associates, Fort Worth, Tex., cautions clients to be mindful of currency exchange rates and, in particular, the prospect of continuing declines in the value of the dollar relative to other currencies and asset classes.

“For the first time, we’re seeing the dollar challenged as the currency of choice, which is reflected in the higher valuation of gold and other commodities,” says Diesslin. “As the dollar declines in value, people’s purchasing power is also reduced. And purchasing power is the cornerstone of any income plan.”


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