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.
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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.