The history of annuities is one of growth and innovation. The original concept evolved from A.D. 222 when Roman scholar Ulpianis was credited with developing the first actuarial table. This progressed into individuals making large payments into an annua, (Latin for annual stipend) to receive annual payments till death or for a specified period.
Roman soldiers were paid an annua to compensate for their service. From then on, into the Middle Ages, society continued to use pools of cash to pay individuals dividends or stipends until death, with the proceeds of these programs paying for wars or public works.
In 1720, the Presbyterian Church in the Americas started providing annuities to its aging ministers and families, likely the first annuities issued in North America.
Today, we see annuities being used frequently for a variety of reasons. Certain annuity products and their complexities present unique challenges to advisors in this day and age, but they also present numerous opportunities to make solutions for the right type of client.
A few of the benefits annuities can provide include safety of principal, opportunity for growth of funds invested with the insurance company, diversification, guaranteed lifetime income and significant income tax advantages. One key additional benefit in variable annuities is the ability to exchange sub-accounts with no current income tax consequences and at low or no cost.
Today’s annuities come from a long road of transformation. I will help shine a light on their evolution and identify some of the advantages that have successfully been used by our firm for more than 35 years to solve specific client goals and objectives.
In 1653 France, under Louis XIV, an Italian banker named Lorenzo DeTonti implemented an investment plan for raising capital, likely borrowed from ancient Rome. The plan involved a lump sum paid by the participant, who would then receive income each year. As participants died, the income to those remaining increased. Then, the last survivors would receive the highest benefit — an early version of mortality credits. Called a “tontine,” this set-up signaled the birth of annuities.
In 1913, the 16th Amendment to the United States Constitution allowed Congress to levy taxes on income. The exclusion that was made for life insurance and annuity products was secured through efforts from the National Association of Life Underwriters (now known as NAIFA). These benefits still stand today, although amended much over the years. The basic premise is that you can accumulate dollars inside of life insurance and annuity products with income tax deferral until the cash is withdrawn for use or paid out as a life insurance death benefit. Some accumulations are distributed tax free.
In the 1950s, U.S. life insurance companies started issuing deferred and immediate annuities. They typically were for large cases and had many fees and charges. In 1963, a company in Philadelphia called the First Investment Annuity Company (FIAC) issued a deferred variable annuity. This “investment annuity” provided tax deferral to any investment that was placed in it. For example, a certificate of deposit, mutual fund or shares of stock could benefit from tax deferral when “wrapped” by the annuity, even if the owner had purchased those accounts or shares years prior. The investment annuity was an immediate hit with advisors across the country, because they saw the advantages of tax deferral for depositors and clients.
The IRS consistently issued more than 70 public and private rulings from 1963 through 1977 that this investment annuity was acceptable within the tax code. However, it wasn’t long before the lack of tax revenue due to this plan’s existence caught the attention of Congress. In 1977, the IRS issued Rev. Rul. 77-85, which was made public law when the Senate passed HR 3477. This immediately closed down investment annuity products. However, through a grandfathering provision, clients had funds in these plans for decades.
By the late 1970s the modern no-load variable annuity had been developed. Prior to this time, most annuities were front-loaded, similar to an A-share mutual fund. By contrast, no-load annuities have a contingent deferred sales charge that’s applied to redemptions within the sales charge period; which is typically five to 10 years. The Spectrum variable annuity was a no front-load annuity that had a contingent sales charge within it. In 1978 the Spectrum variable annuity had deposits of $11 million, and by 1980, assets had blossomed to $250 million. Some feared the IRS would move against these plans like they had the investment annuity, and they did.
Rev. Rul. 81-225 required an owner of a variable annuity contract to have a separate account, meaning you could not offer a publicly available mutual fund within the variable annuity. To be sure, a company could clone a mutual fund and offer it within the insurance product. However, it could not be the exact same fund — separate account only.
In the 1990s variable annuities hit their stride, taking in $3.5 billion that year. By 1999, nearly $63 billion was received. Today, we have variable annuity plans that offer a host of outstanding benefits to clients. Some of these benefits are universal and come from our tax code or contract law, such as tax deferral, contractually named beneficiaries and successor/ownership aspects. Other benefits come from the company, like death benefits, living benefits and sub-account choices.
Will adverse rulings or new laws change these plans once again? Based on history, it is highly likely we will see continued change on this front.
Today, fixed indexed annuities offer a formula-based crediting of excess interest by the issuing company. This differs from a fixed non-indexed annuity where excess interest is determined by the company from time to time and usually at the discretion of the company’s board. It’s the difference between “we may pay excess interest” and “we will pay excess interest.”
Charles Darwin believed the species most adaptable to change would survive. With variable annuities, our clients have the opportunity to adapt to economic changes by shifting assets from and between the various sub-accounts that represent different asset classes and sectors. The ability to make sub-account exchanges is a paramount benefit in the variable annuity. To effect these changes with little or no cost and with no immediate tax consequences is outstanding.
But who makes this call? What guidance and theories are best to use as direction for the allocation among the various choices? Some plans have hundreds of sub-accounts. Many advisors rely on third-party asset managers (RIAs) for this vital function. This non-core activity can be outsourced for efficiency and represents a cost-effective way to meet a critical function. By partnering with a proven RIA, the advisor can concentrate on gathering assets and other critical core functions and activities.
Even through all these changes, the variable annuity remains a solid planning tool for advisors and clients. Advisors need to make sense of all this variety in a solid and systematic way to develop appropriate and suitable allocation models across their clients various risk profiles.
The evolution of today’s modern annuity products benefited from DeTonti’s early framework; it helped financial professionals become more efficient and client-focused. The future of annuities may change as government and economic forces shift, but these products will continue adapting to suit the needs of our clients as we help them address their goals and objectives.