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Annuity Suitability |
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Existing Investments
Annuities vs. Other Investment Alternatives
Variable Annuities
Variable annuities are typically viewed as an alternative to mutual funds or equities. (This discussion will assume that the investor in the variable annuity elects to invest in equity-based subaccounts. For variable annuity owners who choose to invest in the contract's fixed account, the annuity will behave more like the fixed annuities described above.) As we've mentioned, some variable contracts offer "clones" of popular mutual funds as their investment subaccounts -- so this comparison seems to make sense at a superficial level. There are, however, substantial differences that may make variable annuities more (or less) suitable than mutual funds or stocks.
Income taxation. One of the prime advantages of investing in a variable annuity, as opposed to stocks or mutual funds, is that earnings in the annuity grow tax-deferred. And the investor has the opportunity of "timing" withdrawals to take advantage of lower tax brackets or net the annuity earnings against other ordinary income losses the investor may incur in a particular year. Another advantage is that the tax-deferred growth within the account is not included in calculating the AMT or determining whether Social Security benefits will be taxed. A disadvantage is that deferred variable annuities are subject to a 10% penalty on withdrawals prior to age 59½.
There is another tax disadvantage that variable annuity investors face. All withdrawals taken from a variable annuity will be taxed as ordinary income. This means that the tax-deferred growth that accumulates within the contract will be taxed at the investor's ordinary tax rate. By contrast, an investor purchasing shares of stock that appreciate in value will be taxed, when the stock is sold, at a reduced capital gains tax rate. Mutual funds must distribute any realized capital appreciation annually, but this too will be taxed as capital gains, not as ordinary income. Qualified dividend income received from a stock portfolio or mutual fund will be treated as dividend income and be taxed more favorably than ordinary income. The central tax question for the investor is: Will the accelerated tax-deferred growth (so-called "triple compounding") available under the variable annuity more than compensate for the higher tax rate applied to that growth when it is withdrawn? The answer to that question depends on the investor's current tax rate, the anticipated tax rate that will apply when the withdrawal is taken and how long the earnings will grow tax-deferred. Advisors should try to project which investment vehicle (variable annuity or mutual fund) will yield the greater after-tax net income to the client. Obviously, such projections are not always an easy chore. To further complicate the advisor's task, if the annuity is annuitized, rather than a simple lump sum withdrawal, the tax-deferred growth continues to be earned even in the annuity period. Depending on how long the annuity period lasts, continued tax-deferral can add significantly to the value accumulated by, and ultimately distributed to, the contractholder.
(Please note: this analysis does not apply to the comparison of fixed annuities and other fixed-income alternatives discussed above, since there is no difference in their tax treatment -- both bond interest and annuity earnings are treated as ordinary income.)
Estate taxation. There is an estate tax difference between variable annuities and mutual funds. Upon death, beneficiaries inherit most securities, such as stock and mutual funds, at a "stepped up basis". This is not the case with variable annuities. Beneficiaries who inherit a variable annuity also inherit the original owner's cost basis. For example, Mr. Brill purchased 1,000 shares of OmniGrowth Mutual Fund at $50 per share. At his death, the value of his OmniGrowth shares is now $125,000. He leaves the shares to his daughter, who sells them six months later for $140,000. The daughter will pay capital gains tax on $15,000 ($140,000 sales proceeds minus her $125,000 stepped-up cost basis). If Mr. Brill had invested his $50,000 in a variable annuity subaccount identical to OmniGrowth, his daughter would inherit her father's contract with his original $50,000 basis. If she liquidated it for $140,000, she'd be faced with a $90,000 capital gain. For investors focused on the efficient transfer of wealth to the next generation, variable annuities may not be as suitable as other comparable investments. [Please note: the current federal estate system (rates, step-up rules, exclusions, etc.) is scheduled to revert to pre-2000 levels in 2010 but Congress will probably revise the system before then.]
Death Benefit. Deferred variable annuities offer a minimum death benefit that mutual funds or other securities cannot. In most variable contracts, the minimum guaranteed death benefit is the greater of initial contributions to the contract or the current value at the time of death. These guarantees can be comforting to investors concerned with leaving as much as possible to their heirs. If the value of the subaccount falls and the contractholder dies, the heirs will be guaranteed the contractholder's principal. If the investment had been placed in a comparable mutual fund that declined in value, the heirs would receive only its current value. At first sight, this seems to be a major advantage for investments held in a variable annuity. But that protection comes at a cost. A mortality expense is applied to the contract and the protection it affords is only in the case of a market decline. If the value of the account at the time of death is greater than the original investment, the heirs will receive that increased value the same as they would have had the investment been in a comparable mutual fund. In effect, the variable annuity's insurance component provides no extra value for the heirs if the investments in the subaccount grow. On the other hand, if the contractholder had purchased a life insurance policy and invested in a comparable mutual fund upon his death, his heirs would receive the current value of the shares plus the life insurance proceeds. Assuming the life insurance proceeds exceed the amount of any decline in the shares value, the heirs would see a greater inheritance than the minimum guaranteed death benefit provided by the variable annuity. And if the value of the shares increased, the heirs would receive that increased value, plus the life insurance proceeds. The variable annuity, by contrast, would simply pay the increased value. Advisors should be keenly aware of the mortality charge a variable annuity contract imposes on the investor, and the amount of real protection the minimum death benefit provides. That is especially true when the contract offers enhanced death benefits for an "enhanced" cost. In these cases, the minimum death benefit is ratcheted up in some contracts based on a fixed rate of growth, in others, based on actual growth in the subaccount. In periods of great market volatility, these enhanced death benefits may well be worth their price. A cost-benefit analysis may be difficult, but advisors should try to analyze the tradeoff, nonetheless.
One additional point is worth noting. The mortality charge is usually assessed as a percentage of the account value, usually 10-30 basis points (0.10 0.30%) per year. If the value of the account grows, so does the mortality charge. Yet as noted above, the minimum death benefit is really only of value in cases where the account value has fallen at the time of the contractholder's death -- it provides no additional benefit if the account has grown. So, perversely, the contractholder pays more in mortality charges as the guaranteed death benefit becomes less valuable to his heirs. Some annuity companies realize this illogical outcome and now base the mortality charge on the actual risk undertaken by the company.
The mortality charge should be viewed as a risk management decision. For some investors, the protection given to their heirs may be well worth the cost. Other investors, who are not particularly concerned with maximizing transfer of wealth to their heirs, may view the mortality charges as a drag on investment performance. For these investors, an investment in a comparable mutual fund might be more suitable.
Enhanced living benefits. Newly-issued variable annuity contracts offer many "bells and whistles": GMIBs, GMABs and GMWBs, or possibly provisions that include all of these in one package. All of these enhanced living benefits (discussed in great detail in Chapter 1) come at an additional charge. They all offer additional levels of protection to the variable contractholder that are not available to investors in a comparable mutual fund. The question for the investor and his advisor is whether the benefits justify the additional cost. Advisors should approach this question the same way they approach a variable annuity's enhanced death benefits as a risk management decision. If the contractholder is not interested in the protection these provisions offer, then the additional cost simply acts as a drag on investment performance. If the contractholder feels the risk protection is of some value to him, then the question becomes: Is that value worth the cost? The cost is usually a straightforward amount set forth in the contract. The actual value of the enhanced living benefits for each prospective contractholder is more difficult to assess. Some annuity companies offer training seminars to provide advisors with the tools necessary to evaluate these benefits. If an advisor has access to such training, it would definitely be worth his or her time to attend. At a minimum, the advisor should seriously study all marketing materials and contract language (perhaps augmented by discussions with the company's marketing representatives) to better explain the true value of these benefits to his or her clients. For risk adverse clients, the peace of mind these benefits offer may more than justify the cost.
Surrender charges. Most deferred annuities impose a surrender charge on large withdrawals in the first years of the contract's life. If the contract is surrendered in the early years, surrender charges will reduce the amount of principal available to the contractholder. As noted earlier, surrender charges make annuities a less-than-liquid investment option. Surrender charges are used to cover the upfront "acquisition costs" incurred by annuity companies, primarily commissions to sales personnel. Some deferred variable annuities offer the investor the option of an upfront sales charge or a contract with surrender charges (known as Class A shares and Class B shares, respectively). Mutual funds have the same type of expenses to cover many funds impose either an upfront "load" or sales charge (reducing the amount available for investment) or a back-end load (similar to the surrender charges on variable annuities). To avoid these costs, an investor could opt for direct investment in individual equities or no-load mutual funds.
Investment fees. Both mutual funds and variable annuity subaccounts are actively managed portfolios and both charge a fee to cover the management expense. While a subaccount may be managed by a mutual fund company, and even share its name, there may be differences in the management fees. Advisors should be aware of the management fees charged by the annuities they represent. Typically management fees are higher on subaccounts invested in industry-specific portfolios or portfolios invested in less liquid assets (i.e., real estate holdings); lower on broadly diversified portfolios. The so-called "fixed subaccount" that pays a fixed rate of return usually does not charge a management fee. Knowledgeable investors could avoid (or minimize) these annual charges by investing in and holding a portfolio of individual securities.
Income payments. Annuities are the only investment option that can guarantee a lifetime income, regardless of the length of the measuring life. The periodic income stream from an annuity is part principal and part earnings (and therefore only partly taxable). Income streams from other investments, such as dividends and interest, are fully taxable and never guaranteed to last for a lifetime. Advisors should be careful to make those distinctions when discussing the relative merits of income payment from annuities and other investments. Many deferred annuities are never annuitized, that is, they are used to meet accumulation, not distribution, objectives. That said, all variable annuity contracts do offer guaranteed payout options -- an opportunity not available in other investment options. Of course, other investment alternatives may be used to accumulate wealth, and if periodic lifetime income is eventually needed, that investment can be liquidated and used to purchase an immediate annuity.
Indexed Annuities
Equity indexed annuities -- with their guaranteed minimum rate of return and market derived interest rates -- fit somewhere between traditional fixed annuities and variable annuities. Advisors would be best served if they viewed equity indexed annuities as a fixed annuity with a fixed rate of return (if market returns eventually exceed that minimum, that's frosting on the client's cake).
Many commentators, however, view EIAs as an alternative to indexed mutual funds or investment in index shares (exchange traded funds, or ETFs). The comparisons are not entirely valid. One, indexed mutual funds and ETFs are passively managed portfolios designed to mirror the market weighting of the index components once the portfolio is established, the manger need only update it for changes in the makeup of the index. So, unlike actively managed mutual funds and variable annuity sub-account, management fees are minimal for index funds or shares. Equity indexed annuities rely on index options to mimic the upside returns of the index. Those options expire periodically and need to be replaced. This is a "hidden cost" of EIAs. Two, index mutual funds and index shares must distribute income annually, while EIAs grow tax deferred. Three, index mutual funds and index shares own the underlying stocks in the index, and many of those stock pay dividends. EIAs do not own the underlying stocks, and therefore do not generate dividend income for their contractholders. The upside market returns promised by EIAs are based solely on appreciation of the index's value, not the total return the index shares might generate (stock price appreciation plus dividends). Four, index mutual funds and index shares participate fully in the index's movement -- up or down. The upside market returns promised by EIAs are limited a portion that movement (the participation rate, caps, spreads, etc.). Ratcheting and other mechanisms, as well as the minimum guaranteed rate of return, limit exposure to downside movements. Put another way, the contract holder in an EIA exchanges market risk for reduced upside potential (i.e., a less perfect, inflation hedge).
As with all annuities, equity indexed annuities impose surrender charges. EIAs, more than other types of annuities, are primarily a vehicle for accumulation. Investors in EIAs should plan to invest in the contract for the duration of the stated maturity. Withdrawals from equity indexed annuities prior to maturity can have serious adverse consequences to the actual return earned by the investor. In some contracts, the equity-based rate of return is applied only to contracts that remain in force until maturity. If surrendered prior to maturity, the surrender value of many contracts is based on only the minimum guaranteed rate, not the indexed value. These facts makes EIAs particularly illiquid. Advisors can partially overcome this illiquidity by "laddering" the maturity dates, just as they do with a bond portfolio. Instead of investing the full amount in one contract, with one maturity date, the investor could purchase a number of equity indexed annuities with progressively longer maturity dates. This allows the investor to access his or her principal, at maturity, over a period of years. For example, rather than purchase one large 20-year contract, a client could purchase a contract with maturity in year 7 (the end of a typical surrender charge period), another maturing in year 14 and another in year 20. The first contract would provide a return of principal (plus earnings) in year 7, that could be redeployed to meet the investor's need for income (or other purposes) between years 7 and 13, the second contract could be used to meet capital needs in years 14 through 19, and the final contract completes the return of principal at the end of the 20-year investment horizon. Of course, if the client has no need for the principal at the intermediate maturities, he faces the risk of reinvesting those proceeds on less advantageous terms.
Two centuries later, Mrs. Dashwood's admonition still rings true .... annuities are a very serious business, indeed.
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