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.