The single most powerful feature of an annuity is tax deferral, according to Mitch Caplan, CEO of Jefferson National, not features like guaranteed income and riders. “Our philosophy is that the most powerful thing you can provide the advisor and their client is the ability to save in a compounding way utilizing tax deferral,” he said.
Investors can get tax deferral through an IRA or 401(k), as well as other products like health savings accounts and 529 plans, but “given that they have limitations in contribution amounts, it’s pretty easy to start maxing out on what you could do in terms of being able to build for the future,” he said in an interview with ThinkAdvisor.com in March.
Using an “annuity chassis” to provide tax deferral would work, he said, “but only if it was low cost.”
“A traditional asset allocation model probably provides you with 100 to 200 basis points in additional returns through tax deferral annually,” Caplan said. “That means the cost you pay for that tax deferral has got to be very low in order for the benefit to accrue to you.” However, in the mid-2000s, “most companies that were providing tax deferral through an annuity structure charged on average 130 basis points. So in many cases it was wiping out either some or 100% or more of the benefit associated with tax deferral.”
As a result, the industry moved away from selling the tax deferral aspect and focused on benefits like riders, lifetime income guarantees and death benefits. “They needed to sell on the sizzle of something,” Caplan said.
Jefferson National launched Monument Advisor, an investment-only variable annuity, in 2005. It charges a $20 a month flat fee, Caplan said, and the average account balance today is $250,000. “At a quarter of a million dollars when they’re paying $240 a year, it costs them about 10 basis points. At 10 basis points, it preserves the value of tax deferral.”
It’s All About Education
Caplan said that what the advisors his firm serves really want is education and information. “They, generally speaking, have little to no interest in being marketed to,” he said.
Ten years ago, when the firm first launched its IOVA, “when you tried to discuss the use of an annuity as a tax planning vehicle with an advisor, they just didn’t believe that such a thing existed,” Caplan said. “Today, advisors definitely understand that there is this construct of using an annuity chassis to provide an investment-only variable annuity, and it is about the power of tax deferral.”
In educating them about using an annuity as a tax-planning vehicle, Caplan said the conversation revolves around asset location and asset selection. Clients of the advisors his firm works with have already maxed out their IRA and 401(k) contributions, he said, because those accounts are the “first line of defense regardless of where you are” in the retirement planning life cycle.
“What is the appropriate amount of your client’s assets that [they] should put into a vehicle for saving and building wealth for retirement?” he said. Once advisors determine the appropriate percentage of a client’s account to defer, they have to find the right products.
“You should not be putting in that tax wrapper an S&P index fund or an ETF,” he said. Caplan recommends using variable insurance trusts, “which are effectively ’40 Act mutual funds cloned into a separate product.”
Ultimately, advisors should pick funds that “by their very nature are tax inefficient; either they’re generating high current income or they’re tactically traded so it’s creating short-term capital gains, which is the same as being taxed at an ordinary income rate. Or anything that has high dividends associated with it.”