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Can We Be Optimistic? Part 2

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Last week, we discussed the challenges retirees face due to inflation and taxation. In this blog, we’ll look at longevity risk and one possible solution.

Of the future challenges, which should be of most concern? Perhaps it is the possibility that your clients might live so long as to one day outlive their assets.

Consider that in 1900, the approximate life expectancy was 45 years. In 1990, it had increased to 75. Because of the advances of science and medicine many of us can now expect to spend 20, 30 or more years in retirement. In fact, one of the fastest growing groups in America are the so-called “centurions”—people living beyond age 100. With this increased longevity comes the risk of depleting your clients’ assets during their lifetime and possibly outliving their income.

When considering the effects of inflation, volatile interest rates and financial markets, taxation and the possibility of outliving one’s income, we must wonder if there is a product that can help meet these challenges.

Fortunately, the answer for some of your clients may be the tax-deferred fixed annuity. Fixed annuities provide a minimum guaranteed interest rate.

Generally, traditional fixed annuities guarantee a higher interest rate for one year; after that, the rate can fluctuate throughout the life of the contract, but it can never fall below the minimum guaranteed rate.

This minimum guaranteed interest rate can provide an attractive alternative when interest rates and the equity markets are particularly volatile.

One form of a fixed annuity is the equity indexed annuity that provides the opportunity for gains linked to an index such as the S&P 500, but with no market risk to principal. If the structure of the equity indexed annuity does generate earnings in addition to the minimum guarantees, those earnings could help offset the effects of future inflation.

The withdrawal options of annuities are also uniquely suited to help deal with the possibility of outliving our assets. At maturity, your clients may decide to withdraw the money that they’ve accumulated in their annuity all at once. Or, they could select from a variety of retirement income options.

Peace of mind

One option will guarantee a monthly income for as long as they live. A guaranteed lifetime income can go a long way to providing the peace of mind needed to enjoy many future retirement years. Plus, annuities provide an opportunity for tax-deferred growth.

The income tax on their annuity’s interest earnings is deferred until they choose to access their savings. This means that as long as the money stays within the annuity they have the triple advantage of:

  • Earning interest on their premium,
  • Earning interest on their interest, and
  • Interest on the money that they would otherwise have paid in current taxes.

Fixed annuities can help your client deal with volatility by providing additional opportunities for diversifying their investments. If your client’s investment portfolio relies too heavily on higher or moderate-risk investments, the safety and guarantees of fixed annuities can provide an excellent alternative. 

People determined to place all of their savings only in vehicles that provide safety of principal can look upon fixed annuities as an option for even greater diversification among safety oriented investments.

Combining the safety of fixed annuities with the advantage of tax-deferred growth provides many conservative investors with a way to increase the net after-tax growth of their earnings without exposing their principal to market risk. To illustrate this advantage consider two $50,000 sums compounding at the hypothetical rate of 6 percent.

(Please note that I am selecting 6 percent to illustrate the effect of taxation on growth only. Actual interest earnings of fixed annuities or other investments could be lower or higher than this rate.)

th taxes being paid each year, the currently taxed sum would grow to $76,322 after 10 years. But if the taxes are deferred, the effect of compounding is more pronounced so the total at the end of 10 years is $89,542. Even if all of the taxes were paid at this time, $78,470 would remain. The net effect is that after taxes more than $2,000 more is left when income taxes were deferred for 10 years. 

Instead of 10 years let’s assume that the entire $89,542 sum continues to grow tax-deferred for 20 years. Now the total would be $160,355. If all of the taxes were paid at the end of this period, $129,456 would remain. That’s almost $13,000 more than if the income taxes were paid each year.

What if the taxes were deferred for a total of 30 years? The original sum of $50,000 would have grown to $287,175. Even after paying all of the income tax on this gain, there would still be a total of $220,765 remaining. Contrast this to the $177,830 that is left when taxes are paid each year. Over 30 years, tax deferral generates almost $43,000 more after all of the income taxes are paid.

Remember, with an annuity your clients pay the income tax on their interest earnings only when they choose to access their savings. So your clients have the advantage of controlling when the taxes will be paid. 

But there is another potential advantage with annuities as well. Instead of withdrawing the money that they have accumulated in their annuity all at once, they could select from a variety of retirement income options. One such option would guarantee a monthly income for as long as they live. Under this option their monthly income would be calculated based on the entire amount accumulated in their annuity before any income tax is paid. Under current tax law, a portion of each payment would be considered taxable income while the remaining portion would generally be considered a nontaxable return of cost.

The favorable tax treatment of annuities can allow funds to accumulate over the years without being eroded annually by current taxes. Then these funds could be used to provide a retirement income guaranteed to last for the rest of the owner’s life, with a portion of that income being nontaxable.

And consider that when left in the annuity, earnings will not affect taxation of Social Security income. For some this can mean that each year’s income tax bill will be lower because the taxes on the annuity’s earnings are deferred as they accumulate, and the tax bill could be lower still because as the annuity’s earnings accumulate they are not considered when determining if the taxpayer’s income is high enough to trigger the inclusion of a portion of Social Security as additional taxable income.

Annuities can also provide advantages when it comes to settling the owner’s estate. When left to your client’s named beneficiary annuities automatically avoid:

  • The expense,
  • The delays and
  • Inflexibility of probate. Bypassing probate can be welcome relief for family members who otherwise might have to struggle with courts and attorneys before they receive their inheritance.

Fixed annuities offer many advantages:

  • They are free from market risk.
  • With fixed annuities your client’s principal is guaranteed.
  • There is a minimum interest guarantee.
  • Income taxes on earnings are deferred as long as they remain in the annuity.
  • Annuities offer a guaranteed lifetime income option.
  • Amounts distributed at death bypass probate when left to your client’s named beneficiary.
  • And, as earnings accumulate within your clients annuity there is no effect on the taxation of Social Security income.

Can we be optimistic about future challenges for our clients?

In spite of what we see on the news every day there are reasons to be optimistic about the future. So consider asking your clients this question: “Of the money you have left, how much do you not want to have at risk anymore so you can feel more confident about the money you want to have at risk?”

For more from Lloyd Lofton, see:


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