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Financial Planning > Tax Planning

Building a better IOVA

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Now that the 2014 tax season is almost behind us, advisors can begin to focus on looking for new ways to enhance tax-adjusted returns in 2015. For many RIAs and fee-based advisors, choosing the most tax-efficient investing strategies is at the core of their planning approach. A quick review of a clients’ 2014 tax return can often show the ‘tax alpha’ opportunity, meaning the ability to decrease current ordinary income and short-term capital gains to improve portfolio returns.

When thinking of the latest and most innovative products available to generate tax alpha, a variable annuity may not be the first thing that comes to mind. But there is a new generation of low-cost Investment-Only Variable Annuities (IOVAs), which were rebuilt and re-engineered from the ground up to confront the challenging dynamics of today’s markets. And no-commission low-cost IOVAs have enjoyed considerable interest from RIAs and fee-based advisors, typically the harshest opponents of using variable annuities in their practices.

Market forces drive innovation

Variable annuities (VAs) were developed in the 1950s as tax-deferred saving vehicles. VAs experienced slow growth until the 1980s, when the Tax Reform Act of 1986 set limits on tax-deferred savings in qualified retirement plans and insurers began promoting the product as an attractive alternative to individual retirement accounts (IRAs).

The 1990s bull market created an urgent investor need for deferring taxes on double-digit returns in their portfolio — and VA sales began to grow substantially. Individual annuity premiums increased from $58.6 to $71.8 billion between 1989 and 1993. By the late 1990s, insurers began offering VA products with a range of enriched insurance guarantees as a way to drive even greater sales and compete with the declining availability of defined benefit pension plans. This ushered in the era of traditional VAs built around underlying insurance guarantees instead of tax advantages — and propelled VAs to become a trillion-dollar industry by 2000. The rise of traditional VAs with guarantees also increased complexity, eliminated transparency, and led to an escalating arms race of features and benefits in the commission-based advisor channel.

The appeal of traditional VAs with income guarantees is based upon the combination of downside protection, upside potential and a guaranteed income stream in one investment package. Many advisors have relied on these traditional guaranteed VAs to ensure that their clients have sufficient income to meet their retirement needs. But with asset-based fees that frequently exceed 2 percent or even 3 percent per year, recent restrictions on underlying investment options, and insurance guarantees that can be difficult to decipher, these traditional VAs have their limitations.

Re-price, re-tool, or retreat

These limitations came to the fore as the VA industry went through a massive shift in the wake of the financial crisis of 2008. In response to the steep market drop, record low yields and ongoing market volatility in the post-crash years, insurers faced  significant capital declines and were forced to raise fees, restrict investment choices and reduce the benefits associated with income guarantees to manage risk on their balance sheet. Some were forced to retreat from the industry entirely. Advisors, clients and consumer advocates responded with a fair amount of criticism — and many remain conflicted on the benefits of using traditional guaranteed VAs.


Technology drives innovation

In response, Investment-Only Variable Annuities have been built to focus on the power of tax deferral, instead of insurance guarantees – essentially going back to their roots, and often at an even lower cost to further maximize tax alpha. But for IOVAs to work, low cost is not enough. Fund choice is critical to allow for advisors to create their desired portfolio. Functionality and flexibility are also key so that advisors can bring VAs into their investment management practice.

With web-enabled functionality to provide portfolio management, trading and mass transaction capabilities, today’s IOVAs allow advisors to employ an expanded selection of funds, including liquid alternatives that use strategies like those favored by hedge funds and elite institutional investors. With features such as an online application process, cloud-based account management and performance reporting, IOVAs help advisors enhance accuracy, speed and efficiency.

Re-engineered as a tax-advantaged investing platform, low-cost no-load Investment-Only VAs can be used in ways that a traditional VA cannot. Providing a broader range of investing solutions, IOVAs can help advisors offer new ways to better meet their clients’ needs—and deepen the client relationship.

Adding tax-alpha through asset location

A simple but highly effective approach to increase after tax returns is to implement an asset location strategy. And the right low-cost IOVA with a broad lineup of funds is an effective solution, once qualified plans are maxed-out. Asset location involves locating clients’ assets between taxable and tax-deferred vehicles based on tax characteristics. The savings and subsequent wealth created by asset location can be substantial, especially for clients in high tax brackets and clients with a portfolio of $1 million or more.

Start by considering the tax efficiency of assets. If they are taxed at lower rates for long-term capital gains, such as buy and hold equities, index funds, ETFs, and tax-exempt municipal bonds, locate these assets in taxable accounts.  If they are taxed at higher rates for short term capital gains and ordinary income such as fixed income, REITS, commodities, actively managed strategies and liquid alternatives, locate in a low-cost IOVA to mitigate the impact of taxes.  The power of tax deferral becomes apparent – advisors can help control how much clients will pay in taxes — and when — to build more wealth.


Manage volatility more tax-efficiently

Advisors can best manage volatility, minimize a range of risks, and achieve maximum diversification for their clients when they can apply more proactive risk controls across a mix of funds. This often includes using alternative investing strategies, such as selling short, leverage or derivatives. In addition, the strategic use of alternative investments can help enhance diversification, reduce risk through low correlation with equity and fixed income markets, and in some cases generate greater alpha. This can help position clients to minimize drawdowns, keep pace with inflation and maximize long-term performance.

With the growth of transparent liquid alternatives – a new category of mutual funds designed to be non-correlated to traditional stocks and bonds – the industry is making the move to democratize alternatives for more investors. Liquid alternatives often include many of the same characteristics as hedge funds, and can use the same non-traditional investing strategies. The added benefit of liquid alternatives is daily liquidity, lower investment minimums, greatly reduced fees and simplified tax reporting.

Yet, many liquid alternatives have tax implications. Like other mutual funds, liquid alternatives are taxed whenever shares are sold, and also taxed each year on any fund distributions, such as dividends and capital gains. And because most liquid alts tend to trade more frequently, generating more short-term capital gains, they tend to be highly tax-inefficient.  

A new approach to retirement income 

A recent white paper published by Jefferson National and retirement income professor Wade Pfau, Ph.D., CFA, evaluates the costs, benefits and income potential of traditional guaranteed VAs and low-cost IOVAs. In “A New Approach to Retirement Income: Next-Gen vs. Traditional VAs,” Pfau demonstrates how the impact of high fees — even in the best of markets — can diminish returns on retirement income accounts, erode the underlying assets, and drive the ending balance to zero more quickly.

Pfau’s research shows that the primary advantage to the variable annuity structure is the power of tax deferral. But just as the power of tax-deferred compounding can grow wealth, its corollary is that the drag of compounding fees can reduce wealth. There can be more efficient ways for clients to generate income and obtain upside potential and downside protection than by using a traditional guaranteed VA for certain market cycles and/or client profiles.   

Running 5,000 Monte Carlo Simulations and using more than eight decades of market data to test a variety of investor scenarios, Pfau concludes that in the majority of scenarios, the low-cost Investment-Only VA is likely to generate income comparable to the traditional guaranteed VA. More importantly, in the majority of  cases , the lower costs of the IOVA reduce the risk of depleting wealth — and increase chances of accumulating more wealth — which might lead to more reliable income and a larger ending balance than the traditional guaranteed VA in the long run.


Tax-optimizing legacy planning

According to the Pew Research Center, roughly 10,000 Baby Boomers will turn 65 every day for the next two decades. In the coming decades, Accenture estimates Boomers will inherit more than $12 trillion from their parents, and will pass on more than $30 trillion to their heirs. But while 60 percent of high net worth investors say a financial legacy is important, 72 percent do not have a comprehensive estate plan, 66 percent do not have revocable trust and 80 percent do not have irrevocable trust.

Trusts can be an effective solution for planning a legacy and controlling the transfer of wealth to heirs or a charity of choice. But tax rates on trust income are high — even at low thresholds. Trust income in excess of $11,950 is taxed at 39.6 percent — the highest income tax bracket — plus the 3.8 percent net investment income tax. So the benefit of tax deferral may be great. By funding a trust with a low-cost IOVA, you can build a diversified portfolio, then minimize, delay or even eliminate the current tax, to maintain more wealth. Trusts that work well with IOVAs include Credit Shelter Trusts or Bypass Trusts, to save more for future generations; Net Income with Makeup Charitable Remainder Unitrusts (NIMCRUT), to reduce taxation of highly appreciated assets; Revocable Trusts to shelter income for clients in high brackets; and Special Needs Trusts.  

Another solution for wealth transfer includes using a non-qualified stretch with a low-cost IOVA to generate a lifetime income stream for heirs. Employing low-cost IOVAs for legacy planning can help create more wealth for the next generation of family members — and the next generation of clients for your firm.

Innovation drives growth

Recognizing the advantages of innovative low-cost IOVAs, advisors are adopting this new category of tax-advantaged investing platform in record numbers and driving rapid growth. According to Morningstar, annual sales of IOVAs have nearly tripled over the past two years, at $6.6 billion as of third quarter 2014 compared to $2.4 billion as of year-end 2012.  Sales among RIAs and fee-based advisors have become the fastest growing segment.

Tax season may be over. But tax-efficient investing should remain a top priority all year long. There’s a very direct relationship between paying less in taxes each year — and earning higher returns. Low-cost, no-load Investment-Only VAs can be used in ways that traditional VAs cannot to help minimize taxes, enhance performance and increase wealth.  Built as a platform to provide more investing solutions — with low cost, more choice and more flexibility — today’s innovative IOVAs offer new ways to meet your clients’ needs and deepen client relationships. Innovative solutions will help clients succeed. And this will help advisors succeed.


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