A principal goal of many estate plans is to provide incometo the estate owner’s heirs. This goal can often be achieved by using either immediate or deferred annuities. Where the goal is to provide heirs with an immediateincome, an immediate annuity may be the ideal mechanism, especially if the income is to continue for the recipient’s lifetime. The certainty afforded by such a contract is sometimes more important than the amount of each income payment or the fact that the annuity income does not preserve principal. This may be particularly appropriate to satisfy specific beneficiary lifetime income bequests from a portion of assets while the remainder passes to another beneficiary.
Where the desire is for the heir’s income to increase over time — perhaps to keep pace with inflation — an immediate annuity providing for known annual increases is often attractive. While most insurers do not offer immediate annuities with cost of livingincreases tied to some index such as the consumer price index, some do, and more are likely to be offering such contracts in the future in response to a demand that appears to be increasing. An additional attraction is that annuities enjoy creditor protection in most jurisdictions.
A disadvantage to immediate annuities, in this context and others, is their inflexibility. Most immediate annuities, once begun, do not permit modification of the payment amount or commutation, although an increasing number of contracts do.
Read on for 10 situations where an annuity can be the ideal estate planning tool.
1. Purchase of an immediate annuity for heirs outside a trust
Sometimes, an estate owner’s goals include providing a specific and certainincome for specified heirs, apart from the overall dispositive provisions of the estate plan. Here, an immediate annuity is arguably the perfect instrument. Without the certainty of the annuity, a trustee or executor must take into account the market risk involved when invested assets must be accessed each year to make payments to the beneficiary. Thus, the use of an annuity may allow the trustee/executor to invest more money immediately on behalf of the other beneficiaries while still guaranteeing that the income beneficiary will receive all promised payments.
2. Purchase of a deferred annuity for heirs
Where estate planning goals include providing a certainincome for heirs to begin at some future time, a deferred annuity may make sense. Advantages include tax deferral of current gains, which can be of considerable importance if the annuity is owned by a trust subject to the compressed tax rates applicable to nongrantor trusts, creditor protection (to the extent allowed by relevant law) where the annuity is owned outside a trust, and the risk management and investment characteristics of deferred annuities discussed at length in earlier chapters of this book. Disadvantages include the overhead cost of the annuity, which may be higher than that of alternative investments, surrender charges (if applicable), the fact that all distributions from an annuity are taxed at ordinary income rates, and the unavailability of a step-up in basis for annuities owned by a decedent.
3. Purchase of a SPIA by the estate owner for the estate owner and spouse
Impact on the attractiveness of making lifetime gifts to heirs
A primary goal of many, if not all, estate owners is to ensure income for themselves for their lifetimes. This goal often surfaces in discussions between clients and advisors when considering lifetime gifts. “I might need that money” is perhaps the most common objection raised by many clients to suggestions that they utilize the gift tax annual exclusion in making lifetime gifts to heirs. To the extent that the estate owner is guaranteed that he or she — and his/her spouse, if applicable — can be assuredof required income no matter what, annual gifts to heirs, whatever the reason for making them, may be far less worrisome.
If, having secured this required income, perhaps by purchasing an immediate annuity, a client feels able to make more lifetime gifts than he or she otherwise would, the result can be both greater net wealth transferred to heirs — due to lower transfer tax and estate clearance costs — and greater emotional satisfaction. One can live to see his heirs enjoy lifetime gifts. One can also see how well such gifts are managed. For the parent or grandparent concerned that sizeable inheritances might spoil the kids, being able to see how well those kids deal with the money can be both gratifying and informing. If the kids mishandle such gifts, estate plans can be changed, perhaps by adding additional spendthrift provisions.
Implications for the estate owner’s asset allocation decisions
Even where lifetime gifts are not a concern, adequate income for the estate owner(s) is usually a key estate planning goal. “We want to provide for the kids and grandkids, but first we’ve got to take care of ourselves” is a refrain familiar to all estate planners. Allocating a portion of one’s retirement portfolio to an instrument designed specifically to produce income can help one achieve this key planning objective, to the extent of making the allocation of remaining assets easier, or at least, less worrisome. This can be done using either a deferred annuity or an immediate annuity.
4. Using the guarantees in a deferred annuity to provide portfolio insurance
A fixeddeferred annuity provides three guarantees to its owner:
- A guarantee of principal. The money invested in a fixed deferred annuity is guaranteed against loss by the insurer.
- A guaranteed minimumrate of return.
- Guaranteed annuity payout factors.
The first two guarantees provide a known minimum return, on the portion of one’s portfolio allocated to the annuity, which has the effect of lowering the overall principal and interest rate risks of the entire portfolio. Moreover, the assurance that this known future value can be converted into an income stream that will provide at least a certain amount of money each year can make projections of one’s future cash flows less problematic.
A variable deferred annuity does not offer the first two guarantees to the living policy owner, except to the extent that annuity values are invested in the fixed account. However, it provides others. The guaranteed death benefit always provides assurance that heirs — not the living policy owner — will receive, at a minimum, the amount originally invested or the account balance at death, if greater. Enhanced death benefit guarantees, common in newer variable contracts, can assure heirs of the greater of that original investment or account balance at death or some other potentially higher minimum amount; perhaps the account balance at some policy anniversary prior to death or the original investment, compounded at some specified rate of return. If the minimum amount that will pass to heirs is a serious estate planning concern, the guaranteed death benefit may be worth its cost.
The guaranteed living benefits in today’s variable deferred annuities may provide even more comfort for the estate owner in making his asset allocation decisions, precisely because of the refrain noted earlier, namely: “We want to provide for the kids and grandkids, but first we’ve got to take care of ourselves.” The guaranteed minimum income benefit, guaranteed minimum withdrawal benefit, guaranteed minimum accumulation benefit, and provisions combining all three features can assure the estate owner that, irrespective of the performance of the investments in the annuity, certain minimum income and/or future lump sum values will be available.
See also: What do annuity buyers want?
Many critics contend that the costs for these provisions outweigh the benefits that they are likely to provide. The mathematics supporting such a conclusion — if any are supplied — often rely upon historical averages and probable life expectancies. This is not to say that all such criticisms are invalid, or that the logic and mathematics are never valid or persuasive. They may be both. However, it is the authors’ contention that the certainties these riders provide can be very important to many estate owner clients on an emotional level. These certainties, with regard to that part of a client’s portfolio invested in annuities providing them, can enable the client to make asset allocations with regard to money that the client might not otherwise feel comfortable making. In addition, it’s important to note that even though the client may come out with less money in the long run on average, the client is still guaranteeing that a particular minimum amount will be available, which may be more consistent with a client’s goals than merely having the most dollars at death by investing heavily in equities.