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Annuities in Medicaid planning: What you need to know

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Last year, the U.S. Court of Appeals for the Third Circuit handed down an opinion on Medicaid-compliant annuities that could affect Medicaid planners across the nation. The court in Anabel Zahner v. Secretary of Pennsylvania Department of Human Services overruled a Pennsylvania District Court opinion, which left many scratching their heads about the use of short-term annuities. This opinion is only binding in the states covered by the Third Circuit (Delaware, New Jersey, Pennsylvania and the U.S. Virgin Islands), but it’s likely to have far-reaching effects on the use of the Medicaid investment in other states.

Originally, the opinion was based on three families who gifted large sums of money. They also bought short-term Medicaid-compliant annuities for the purpose of paying for a nursing home during the period of ineligibility created from the large gifts. Under federal rules, the annuity should not be considered an asset or resource, and the purchase of the annuity is also considered to be a proper transfer of funds (i.e., a transfer that does not create an additional penalty period). These families did their own version of the modern “half-a-loaf” planning technique.

Modern half-a-loaf planning

Before the Deficit Reduction Act of 2005 (DRA), a common planning technique was to give away half of the client’s assets and use the other half to pay through the penalty period created by the gift, known as the half-a-loaf plan.

When Congress passed the DRA, it took proactive steps to curtail this activity. The principal way of doing so was to change the penalty start date from the date the gift was given until the person who applies for Medicaid is “otherwise eligible.”

Under the DRA, a person would give away approximately half of the assets to create a penalty period when the patient’s resources fell below the state limit. To get them further below the state limit, the remaining half of the assets would be used to purchase a Medicaid-compliant annuity with a term equal to the length of the penalty period caused by the gift. This process is known as the modern half-a-loaf.

These plans are primarily used by people with limited resources to set aside funds for maintaining a home or to enhance the quality of life for the patient with the gifted funds. The penalty periods do not end up being considerably long. Because the penalty periods are relatively short, the annuity term must also be relatively short, which is what the Pennsylvania District Court took issue with.

The Third Circuit wrote an interesting opinion that parses out every major and minor aspect of Medicaid-compliant annuities and reaffirms the viability and use of annuities in Medicaid planning — especially short-term annuities, which is something the district court opinion had ruled against. Here’s what happened:

The annuity safe harbor

The court clearly articulates Medicaid rules have created a safe harbor for resources placed within certain types of annuities. “Congress created a safe harbor pursuant to which certain annuities are not considered resources for purposes of Medicaid eligibility.”

The concept of the safe harbor is something that even a layperson can easily understand. This is a carved-out exception to the rules on what is a countable asset when determining Medicaid eligibility. Congress created the safe harbor rule because it has also implemented rules to encourage people to save for their retirements. By exposing those assets to the threat of a long-term care spend down, Congress has been keenly aware of the moral hazard inherent in such a problem and has also chosen specifically not to provide universal health care coverage for long-term care. So a delicate balance is struck.

Assets can be preserved in the form of an income stream, but that income stream has to be set up with strict, rigid requirements. Such requirements form what we now commonly refer to as the Medicaid-compliant annuity.

Annuities are not a sham

The district court opinion specifically found that short-term annuities were considered to be sham transactions. The court alleged that the annuity term was so short that it was not a real investment, but merely a clever way around the Medicaid eligibility rules.

When overruling the district court, the Third Circuit took a different approach. They evaluated the nature of the investment and found it was a proper investment because it met the general understanding of the term. Additionally, it pointed out that all insurance products are licensed by a state insurance commissioner. These short-term annuities are licensed insurance products and are approved for sale in Pennsylvania and other states. Insurance commissioners do not inherently approve sham investments for sale to the public.

Additionally, one of the reasons the district court was skeptical about short-term annuities was because the fee charged for setting up the annuity actually caused a loss in value. The Third Circuit differentiated between the investment itself, which paid a modest interest rate, and the fee to show it as being akin to paying a Medicaid planner a fee for advice. Plus, if an investment has to make money to not be a sham, investments that lost money from market fluctuation would certainly not withstand the district court’s analysis, with or without a fee.

“Actuarially sound” means less-than

Another issue the two courts took on was the fact that there has been a lack of an explicit definition to the term “actuarially sound.” Clearly, actuarial soundness as to the length of the annuity is capped at the Social Security Administration (SSA) life expectancy table. Beyond knowing what the ceiling is, there is a dearth of direction about whether there is a floor. In absence of an explicit floor, the annuity companies have issued annuities that are fully Medicaid compliant with terms as short as only a few months long.

Pennsylvania asserted that an annuity is only actuarially sound if it is for the full length of life expectancy under the SSA chart and that anything more than a minor downward departure from that is no longer actuarially sound.

The Third Circuit found that, since no minimum term was explicitly set by law, it was reasonable to conclude that any term less than full life expectancy would still be considered actuarially sound.

No sniff test

The district court invalidated short-term annuities based on what it called a “sniff test.” To the district court, the short-term annuity transaction did not smell right and therefore should not be allowed.

The Third Circuit held that a judge’s pseudo-olfactory senses are not an appropriate measure of the validity of a financial transaction when determining Medicaid eligibility. It further went on to hold that the applicant’s motives were completely irrelevant as long as they followed the Medicaid rules. In doing so, it authored one of the best lines in any opinion concerning the concept of Medicaid planning: “Financial planning is inherent in the Medicaid scheme: annuities are not barred from the safe harbor, and the look-back period that considers gifts as resources for purposes of Medicaid assistance is of limited duration.” 

Federal Medicaid law pre-empts state insurance law

Pennsylvania has an interesting state law that requires all immediate annuities to be assignable. Relying on this rule, the state asserted that any annuity sold that was non-assignable was contrary to state law and when viewed in light of the requirement for assignability, would not be Medicaid compliant. It further argued that if it was not Medicaid compliant, the purchase of the annuity would create a transfer penalty and could not be viewed as a non-countable resource for eligibility purposes.

In what was likely the boldest move by the Third Circuit, the non-assignability rule was considered fully trumped by the federal Medicaid law. Its rationale: Because Pennsylvania chose to participate in the Medicaid program, that program had to recognize annuities that complied with federal Medicaid law as being compliant. The court relied upon the Supremacy Clause of the U.S. Constitution to basically say if a state wants to run a Medicaid program, it has to allow people to use Medicaid-compliant annuities.

The Third Circuit reminded Pennsylvania that its participation in Medicaid was voluntary and suggested it could choose to pull out of it if the state did not want to comply with its requirements.


Although this opinion is only binding in the states covered by the Third Circuit, Medicaid planners in the U.S. still need to be aware of it.

Ideally, Pennsylvania’s Department of Human Services should take heed and no longer challenge the use of short-term Medicaid-compliant annuities at the caseworker level. If the state properly applies the Zahner opinion, Medicaid planners should have no problem doing effective modern half-a-loaf strategies with their clients as those situations warrant it. 

In other states where there is pushback — either overtly through state rules that limit the use of short-term Medicaid-compliant annuities or where states informally deny them at the caseworker level — Zahner provides fresh and compelling ammunition to launch a challenge at the federal level against a state’s negative case action. This could have the impact of greatly expanding the use of short-term annuities in states where such a practice is currently verboten and also keep other states that may have attempted to curb their use from doing so in the future.