Annuities have, for many years, been the subject of considerable debate among financial planners, insurance agents, financial journalists and academics. While some of this discussion is dispassionate, a surprising amount of it is not. Much of what is written on the subject — especially by those opposed to annuities — is outright polemic. The debate has become, for many, a feud — as if one must either be for annuities or against them.

This is both unfortunate and absurd. It is unfortunate because the tone and level of discussion regarding the appropriateness and value of annuities in financial planning often sinks to the point of mere diatribe, in which the search for genuine understanding is abandoned for the sake of making one’s case. In that sort of debate, as in war, the first casualty is truth. It is absurd because it rests upon an absurd premise — that an annuity, which is simply a financial tool, can be, in and of itself, inherently good or bad.

We are neither in favor of, nor opposed to, annuities. Instead, we view, and strongly encourage the reader to view, any annuity as a tool; the appropriateness and value of which necessarily depends upon how well it does the job to be done, and how well it accomplishes the planning objectives compared to other tools that are available. Here, we will evaluate some of the more commonly advanced arguments for annuities, and attempt to supply some balance. In our next piece, we will look at some of the most common arguments against annuities, and what that means for our industry.

1. Annuities provide valuable tax deferral opportunities.

Many proponents of deferred annuities point to tax-deferral as a great advantage of these instruments. Indeed, many commentators have stated, flatly, that tax deferral isthe main attraction of deferred annuities — implying that it must be the main reason for purchasing one. Others have argued that the real value to such deferral is the control it gives the contract owner. Because there are no required minimum distributionsapplicable to deferred annuities, and because the contract owner can decide when, and in what amounts, to take distributions, the deferred annuity has been labeled by some as the perfect tax control device.

Certainly, tax deferral has value. Some commentators have observed that it enhances even further, the miracle of compound interest. Jack Marrion refers to this enhancement as “triple interest crediting.”

Money that remains inside an annuity grows free from current income taxes. Not only does the principal earn interest (simple interest at work), and the interest earn interest (compound interest at work), but the money that would have gone to Uncle Sam also earns interest (tax-advantaged interest at work).

Moreover, the control over the timing of taxation of gain enjoyed by the owner of a deferred annuity is unquestionably worthwhile. The annuity owner may choose to take distributions in years of unusually low income or when such distributions can be netted against ordinary income losses. Moreover, the income earned in an annuity, but not yet distributed, is not countable for purposes of the alternative minimum tax or the taxability of Social Security benefits.

Yet the tax deferral and tax control provided by a deferred annuity are not entirely free. There are costs to these benefits, and the costs are not always acknowledged by those who proclaim the benefits. What are these costs?

Insurance charges. These apply only to variable annuities. The insurance charges, or the sum of the mortality and expense (M&E) charge and any separate administrative expense charge, are usually the largest component of the overhead cost in a variable annuity. 

Surrender charges. Many deferred annuities assess surrender charges for distributions exceeding a specified amount or a percentage of the account value, if taken during the surrender charge period. These charges are a limitation upon the control the annuity owner enjoys over the money invested in his annuity.

Early distribution penalty. In addition to any contractual surrender charges, the Internal Revenue Code imposes a penalty tax on distributions taken from a nonqualified annuity by an annuity owner who is under age 59½, unless the distributions qualify under certain very specific exceptions. The penalty is equal to 10% of the taxable amount of such distributions. Like surrender charges, this penalty tax is a limitation on the tax control enjoyed by the annuity owner.

Ordinary income treatment. All distributions from an annuity are taxed as ordinary income. The preferential tax treatment of long-term capital gains, and qualified dividends, enjoyed by many other investment alternatives, is not applicable to the gain in an annuity. This is true for all distributions — partial withdrawals, total contact surrenders, or death benefits — to the extent that there is gain in the contract, and it applies whether a distribution is taken as a lump sum or in the form of annuity income.

Does ordinary income treatment constitute a disadvantage of deferred annuities? If someone is comparing a deferred variable annuity to investments such as stocks, commodities, or mutual funds, the answer might be yes. Much of the gain derived from these investments will, if the investment is held for at least one year, qualify as long-term capital gains, and/or may receive qualified dividend treatment, both of which enjoy taxation at rates significantly lower than ordinary income rates — especially for high-income investors. In addition, qualified dividends on stocks — or mutual funds holding stocks — may also be eligible for preferential tax treatment lower than ordinary income tax rates. The difference in net, after-tax, accumulated wealth and net after-tax income, wrought by the differential between these two tax regimes, can be profound. On the other hand, it’s important to note that one material benefit of the tax-deferral structure for annuities holding equities is the fact that the investor can changeequity allocations without realizing capital gains and generating a current income tax liability. Thus, for portfolios with high enough turnover, the benefits of tax deferral can still theoretically outweigh the less favorable ordinary income treatment.

On the other hand, when comparing a deferred fixed annuity to investments such as certificates of deposit or bonds, the ordinary income treatment of annuity distributions may not represent a disadvantage at all, simply because the interest earned on CDs and bonds is taxed in exactly the same way. In such a scenario, taxation will be subject to ordinary income treatment either way, yet the annuity’s ordinary income gains are at least tax deferred.

It should be noted that the benefit of tax deferral in a deferred annuity is not limited to the accumulation phase, or the period from contract inception to the point where the owner begins taking distributions. Distributions taken as an annuity are taxable only to the extent that the annuity payment exceeds the excludible portion, calculated according to the annuity rules of Section 72(b). Gain not yet received, by this method, continues to enjoy tax-deferral until all gain has been distributed, which occurs when the annuitant reaches life expectancy or the end of a period certain term.

This opportunity for tax deferral of annuity growth, even during the distribution phase of a deferred annuity is often overlooked by critics of annuities, who often compare the annuity to some investment alternative assuming that both will be surrendered at some future point in a lump sum. The advantage of continuing tax deferral during the distribution period can be very substantial, as was noted in a study conducted in 2002 by Price Waterhouse Cooper, entitled “The Value of Lifetime Annuitization.” 

No step-up in basis for inherited annuities. As was noted above, the gain in a deferred annuity is always taxed as ordinary income, even when distributed to a beneficiary as death proceeds, with the exception of original pre-1979 contracts, as discussed in Chapter 3. When received by a beneficiary, such gain is considered income in respect of a decedent. Most other types of investments held by a decedent at death enjoy, under current law, a treatment known as step-up in basis, in which the cost basis, for income tax purposes, of the investment passing to an heir is stepped-up to its value as of the date of decedent’s death. Thus, a stock, which the decedent paid $1,000 for, but which is worth $2,000 at his death, passes to his heir with an income tax cost basis of $2,000. If that heir subsequently sells the stock for $2,500, he will pay tax only on a gain of $500.

If, however, the decedent had bought a deferred annuity for $1,000 and died without taking any distributions, when the annuity was worth $2,000, the beneficiary would be liable for the tax on the entire $1,000 of untaxed gain, at ordinary income rates.

The authors suggest that, where net wealth passing to heirs is a major planning goal, far better instruments than a deferred annuity may be available. For example, life insurance offers far better tax treatment, if the individual is insurable. The beneficiary of a life insurance policy can receive, free of income tax, not just the full cash value of the policy, but the greater — often, far greater — death benefit.

2. An annuity is the only vehicle that can guarantee an income for life.

One of the most commonly advanced arguments in favor of an annuity is that it is the only vehicle guaranteeing, for a given investment amount, an income that (a) is certain as to amount and (b) cannot be outlived. Strictly speaking, this is not true. Perpetual bonds guarantee an interest rate in perpetuity, in addition to invested principal, but these bonds are sufficiently rare as to qualify as exotic investments. Ordinary bonds cannot guarantee an income indefinitely, because all ordinary bonds have a fixed duration. Most instruments considered by investors desiring a certain income either have fixed durations or generate income only through dividends or interest that are not absolutely guaranteed. Deferred annuities also have a maximum maturity date, by which the owner must either surrender or annuitize the contract, so the claim stated above really applies only to immediate annuities or deferred annuities that will be annuitized.

That being said, there is a huge difference between the income generated by an immediate annuity, or a deferred annuity that has been annuitized, and that produced by any nonannuity alternative. By definition, an annuity is an income stream representing both earnings and the systematic liquidation of principal. To compare the income produced by an annuity with the income produced by some alternative using only earnings on principal is to compare totally dissimilar instruments. Unless it is made clear that one alternative preserves principal while the other exhausts it, such a comparison is utterly misleading.

Yet if income is the only goal for a particular investor, the fact that no principal will remain at the annuitant’s death — or at the end of the annuity period, if a period certain payout is contemplated — may not be as important as the amount of the income. For older clients, the annual annuity payment may be significantly greater than that realistically obtainable from any alternative, given the same lump sum investment. The additional income may, for these clients, be worth the cost of spending the kids’ inheritance. Moreover, a comparison of a life annuity with an alternative investment need not contemplate that all of the investor’s capital will be placed under either alternative. Allocating part of someone’s assets to a life annuity might, in some situations, produce an income that is both certain — with all the emotional satisfaction that certainty provides — and sufficiently larger than might otherwise be achievable. The investor then might feel comfortable allocating his remaining assets to more conservative investments, to reduce investment risk, or to more aggressive ones, to achieve even greater total income or final wealth. In either scenario, the annuity would be performing, not only as an investment, but also — the authors would say primarily—as a risk management tool.

If one grants the advantages to annuitization just described, there remains the question of when the annuity needs to be purchased to achieve these advantages. Would it not make sense for our investor to put his money into some instrument that offers more growth opportunity than a fixed annuity or lower overhead costs than a variable one and simply sell that instrument to purchase an immediate annuity when the time comes to begin taking income?

Many commentators and advisors will answer yes. Supporting this conclusion is the fact that the annuity payout factors guaranteed in a deferred annuity have rarely been as attractive as the payout factors available in the immediate annuity marketplace. Moreover, many investment alternatives may be taxed at Long-Term Capital Gains (LTCG) rates and may even enjoy some degree of tax deferral. For example, the profit from an investment in a nondividend-paying growth stock will be taxed only when that stock is sold, and, then, at LTCG rates.

These are valid points. Tax deferral is not the sole province of annuities, and annuities never get capital gains treatment. However, the guarantee of principal, of a minimum rate of return in fixed annuities, and the guaranteed living benefits available in today’s variable contracts provide a degree of downside risk protection that should not be overlooked. Whether that protection is worth the tradeoffs involved is a question well worth serious consideration. But it is not actually an investment question, even though most critics view it as such. It is really a risk management question.

As to whether investing in some alternative which perhaps offers LTCG tax treatment, during someone’s wealth accumulation phase and then surrendering that investment to purchase an immediate annuity is preferable to locking in guaranteed annuity rates is a question we should consider in the light of longevity trends. Americans are living longer with each passing decade. Is it not possible that medical breakthroughs may so lengthen the life expectancy of the average American that immediate annuity rates, decades hence, will be less attractive than those payout rates guaranteed in today’s deferred annuity contracts? If so — and, especially, if those future annuity payout factors are significantly lower than today’s guaranteed ones — the result could be a significantly lower income, for every year of the investor’s retirement, for each dollar annuitized.

Can we know which scenario is more likely? Not unless we have a functioning crystal ball. Absent that, we can either make a bet that future Single Premium Immediate Annuity (SPIA) rates will be at least as attractive as today’s guaranteed rates and that the risk management features of the deferred annuity will cost us more than the benefits they guarantee, or we can insure against those risks.

Furthermore, it is important to remember that if the alternative investment has created substantial gains over the years, a tax liability will be due upon the conversion of that asset from its nonannuity form to an annuitized payout. This foregoes the opportunity for additional tax deferral. Consequently, it may be more beneficial to accumulate funds within an annuity with the plan of future annuitization, because of the tax-deferral achieved not only during the accumulation phase, but also the tax further deferred by spreading the income recognition treatment across a lifetime of annuity payments.

3. The guaranteed death benefit in a variable annuity provides protection that alternative investments do not offer.

A feature of modern variable deferred annuity contracts often cited by their proponents is the guaranteed death benefit. It offers the annuity investor assurance of a minimum amount which will pass to his heirs, regardless of the performance of the underlying investment subaccounts. If the annuity owner happens to pass away after a severe market decline, the beneficiaries will not suffer from that decline, but will receive a guaranteed minimum amount. The standard minimum death benefit is typically the greater of: (a) the account balance at death; or (b) the amount originally invested, less cumulative withdrawals. Most contracts also offer an enhanced death benefit for an additional charge. The enhanced death benefit may provide that the beneficiary will receive the greater of: (a) the amount originally invested, less any withdrawals; (b) the account balance at death; (c) the original investment, less withdrawals, compounded at some specified rate of interest; or (d) the highest account balance at any of certain specified prior policy anniversaries. Some contracts will include only one of the last two factors.

For investors who are greatly concerned with maximizing the amount passing to their heirs, this guarantee may be very important. It is further argued that this investor might, having the assurance of the minimum death benefit guarantee, allocate his investments more aggressively than he would without that guarantee. If so, the argument goes, the historical risk premium of equities investments, or the amount by which equities returns have exceeded returns on more conservative investments to compensate their owners for the additional risk involved, should offer opportunity both for a greater death benefit — because the guarantee typically is the largest of the account balance at death or other specified amounts — and greater wealth accumulation for the annuity owner during his lifetime.

The authors believe that this argument has merit. However, fairness obliges us to point out that the same objective could be accomplished with life insurance. If the investor is able to obtain life insurance, of a type that is likely to be in force when death occurs, the cost for the coverage could be less than the cost of the guaranteed minimum death benefit. Moreover, the life insurance death proceeds will be payable regardless of how the annuity, or other investment alternative, performs. If the alternative investment never experiences a decline in value, the combination of a life insurance policy and the investment will pay both the face amount of the insurance plus the (appreciated) value of the investment. The premium for the life insurance will always produce more wealth passing to heirs than would be the case if no insurance were purchased. This is assuming that the insurance death benefit exceeds the total premiums paid into the policy.

By contrast, the annuity death benefit guarantee is not certain to produce more money for the owner’s beneficiaries than they would receive without it. If the account balance at death is greater than the other factors taken into account in the guarantee (e.g., the amount contributed to the annuity, that amount compounded at a certain rate of interest, or account balance at some prior policy anniversary), the beneficiaries will receive onlythe accumulated account balance. The presence of the guaranteed minimum death benefit will produce no additional value, unless the owner happened to achieve a greater return with higher risk (and return) investments because of the presence of the guarantee.

Some critics of variable annuity death benefit guarantees believe that the historical upside bias of equity investments means that if the annuity is held long enough, the probability that the death benefit guarantee will exceed the account balance at death is too small to justify the cost of that guarantee. Over the long haul, it is sometimes said, equity investments have historically returned an average of, say, 10% per year. Even after reducing that average return by, say, 2.5% — to reflect the total expense ratio, including subaccount expenses, of a typical variable annuity — the result is an average return of 7.5%. That should, or so the argument goes, produce an account balance at death greater than the original contribution compounded at the 5% or 6% rate typically used in a variable annuity (VA) guaranteed death benefit formula, and far greater than the original contribution. Thus, the argument concludes, the cost of the death benefit guarantee is merely wasted money, nothing more than an annual drag on investment performance.

In the authors’ opinion, there are two serious flaws to this argument. First, it amounts to the notion that the market always goes up … eventually. It is certainly true that the long-term trend of equities markets has generally been upward. However, prolonged bear markets happen, and one cannot be certain that one will not die during, or at the end of, one of them. Second, many death benefit guarantee formulas include as a factor — of which the highest will be paid to beneficiaries — the account balance as of certain prior policy anniversaries. Even the most bullish critic must concede that the upward trend of equities markets is not constant. Corrections happen, and markets often take years to return to a prior high point. A death benefit guarantee that locks in a prior all time high may be of significant value, especially in a period of high market volatility.

With regard to the cost of the guaranteed death benefit provisions in today’s variable annuity contracts, one criticism that is rarely voiced, but which deserves the advisor’s serious attention, is how that cost is calculated. Most, but not all, contracts assess the charge for both the standard and enhanced death benefit against the accumulated account balance in the annuity. The additional charge for the enhanced death benefit varies considerably (as of December, 2011, charges from 20–120 basis points per year, as a percentage of account balance). As the account balance increases, so does the cost for the guaranteed minimum death benefit. Yet, as the account balance and the amount of gain in the contract increases, the probability that the beneficiary will receive more than that account balance from one of the death benefit guarantees decreases. This occurs because the more that the account balance grows beyond the amount originally invested, the less chance there is that it will fall below that amount. The same is true, though to a lesser degree, of the chance that the account balance will fall below the value of that original investment, accumulated at the rate of return specified in the death benefit guarantee — for death benefits that have this option. To the extent that the annual growth in the annuity exceeds this specified rate, the accumulated value will exceed the death benefit guaranteed using that rate. The greater this excess, the less likelihood that the account balance will later fall below that future contributions, accumulated at N% value. Thus, in a situation where the annuity performs well, the contract owner will incur an increasing annual cost for a benefit increasingly unlikely to be payable. The cost/benefit ratio actually decreases with the annuity value.

This pattern does not hold true, however, for the account balance at a prior policy anniversary component. If someone believes that the magnitude of a possible market decline, and thus, a decline in the value of the annuity value, increases with the size of the account balance. The higher the market goes, the bigger the correction is likely to be. The reverse may even be true.

When considering the enhanced death benefit as a whole, however, the fact that the cost of the death benefit guarantee is based on the account balance, rather than upon the value guaranteed, appears — to the authors, at least — to be unattractive, from a cost/benefit perspective. A few insurers have recognized this, and now offer guaranteed death benefit provisions where the cost is more directly related to the amount at risk.

Whether the guaranteed death benefit in a variable annuity (either standard or enhanced) is worth its cost is, ultimately, a risk management question. Regrettably, many critics of annuities insist upon treating it as an investment; one where the cost of what is clearly an insurance feature is seen simply as an overhead cost. In the authors’ view, this makes sense only if the insurance benefits are dismissed as valueless — or, at the very least, unimportant.

They may, for some investors, be just that. For the client who has no heirs, or who dislikes those he has, a guaranteed minimum death benefit is likely to be of little or no interest, and the cost of that benefit would, indeed, be merely a drag on investment performance. For this individual, a variable annuity — because it charges for insurance he does not want or need — is arguably a poor choice.

4. The income produced by an immediate annuity is greater than that achievable from any investment alternative, on a guaranteed basis.

Because an annuity consists both of earnings and the systematic amortization of principal, the amount of income produced by an annuity is virtually certain to exceed that of an investment alternative producing an income consisting solely of earnings or interest. Conceivably, there may be some device guaranteeing an interest rate high enough that its interest income would exceed an immediate annuity payout over the same guarantee period, but it is exceedingly unlikely. For example, as of December 24, 2011, one insurer offers a life annuity with no refund element that will pay a 55 year old annuitant $483 for life, for a single premium of $100,000. The yield required to produce that income for as long as the recipient lives, if principal must be preserved, is about 6%. No investment, that the authors are aware of, can guarantee such a return, as of December, 2011. Although a rise in future interest rates might allow an interest only investment to produce such a return, the payments from the above annuity example would almost certainly be more as well, reflecting the same higher interest rate environment.

Of course, principal is not preserved in an immediate annuity payment stream. To equate the income produced by an immediate annuity with that produced solely from earnings is not a valid comparison, unless the only factor of importance is the amount of income.For example, a 71-year-old male, having that same $100,000 to invest, could — using a different company’s SPIA, as of December, 2011 — receive an income of $536 month from one insurer’s SPIA with a cash refund option, of which approximately 80% ($429/month) will be excluded from taxable income until he has recovered his entire investment tax-free, which would take over 19 years. As of December, 2011, that investor might be able to buy an A rated 20 year tax free bond offering a 4.2% yield. That bond would produce less income; $350 per month versus $429. It would also preserve that investor’s principal. The investor could then pass $100,000 to his heirs, assuming that the bond valued at par at his death. If having as much income as possible on an absolutely certain basis, for as long as he lives is this man’s chief concern, the huge difference in the income of which he can be certain may be worth the tradeoffs, or loss of access to principal, spending the kids’ inheritance. In addition, this investor also faces the risk that the tax-free bond may eventually mature, forcing him to reinvest at potentially lower future interest rates; the immediate annuity’s guaranteed payment stream does not face any such reinvestment risk.

5. The certain income of an annuity may allow a client to act differently with regard to his other assets.

One of the curiosities of the Great Debate over annuities is that it often presumes an either-or scenario. Consider, for example, the following two assertions:

  • Don’t invest your retirement money in an immediate annuity
  • An immediate annuity is the ideal retirement investment

The unspoken implication in both statements is that it applies to a person’s entire retirement portfolio — that one should either avoid buying an immediate annuity with anyof that money or that one should do so with every dollar. Neither scenario necessarily makes good sense.

What often does make sense is the purchase of an immediate annuity with part of a retirement portfolio. There are several benefits to this strategy:

  1. The estate owner who wishes to use lifetime gifting may be more willing to do so having the assurance of a certain income for life.
  2. A risk averse investor, having invested a portion of his retirement portfolio in an immediate annuity to secure income, may be more comfortable allocating more of the rest of his portfolio to higher return — but higher risk — instruments than he would in the absence of those annuity guarantees.
  3. For the client concerned with outliving his retirement portfolio, annuitizing a portion of it may increase the probability that the portfolio as a wholewill provide a required income level given the uncertainties of future market performance.
  4. The emotional value of a certain income for lifeis not necessarily limited to that calculable by investment algebra. The confidence that such a client gains from the certainty of his annuity income, like the peace of mind many homeowners gain by paying off the mortgage, may be worth more than a computation of return on investment would indicate.

For more content from The Advisor’s Guide to Annuities, see:

Which indexed annuity is right for your client?

5 prime annuity prospects

 

The content in this publication is not intended or written to be used, and it cannot be used, for the purposes of avoiding U.S. tax penalties. It is offered with the understanding that the writer is not engaged in rendering legal, accounting, or other professional service. If legal advice or other expert assistance is required, the services of a competent professional should be sought.