Chapter 4 — Investors & Objectives (continued)

During their lifetimes, most individuals will have investment objectives of accumulation, conservation, distribution, and transfer. What makes each client unique, however, is the particular set of circumstances each individual faces. Advisors must apply their creative talents to adapt general investment concepts to each client’s situation. The decision whether the purchase of an annuity is suitable must be based on each client’s unique set of circumstances. And if an annuity is purchased, the advisor should maintain contact with the client to monitor whether the annuity remains a suitable investment as the client’s objectives and circumstances change.

Liquidity — the ability to easily turn an investment to cash without incurring large expense — is a major factor in most investment decisions. Annuities should only be purchased with “long-term money,” i.e., funds that the investor can afford to invest over a long time horizon. Before making a decision to purchase an annuity, the investor should ask:

• “Is this money that I can afford to tie up for an extended period?”
• “Do I have adequate reserves of cash or short-term investments to meet daily living expenses and unforeseen emergencies?”

If the answer to either of those questions is “No,” then an annuity is not a suitable investment.

Annuities can be readily converted to cash, either through withdrawals in the accumulation period or by converting the contract into a stream of income payments. There are, however, a couple of key points to keep in mind. Most contracts impose surrender charges for withdrawals in the early years of the contract. These fees are usually on a sliding scale — beginning with relatively large surrender charges in the earliest years, tapering off over the first five to seven years, and no surrender charges after that point. Surrender charges are typically waived for beneficiaries in the event the contractholder dies.

For annuity issuers, marketing and underwriting costs represent a large upfront expense that must be recovered for the company to earn a profit. Persistency — the average length of time a contract remains in force — is critical to profitable operations. Contracts that are quickly surrendered represent a losing proposition. Surrender charges help recoup some of the upfront costs on contracts surrendered in the first few years, and also remind clients that annuities should be a long-term investment.

Another hurdle applies to deferred annuities only. The IRS views deferred annuities as a retirement savings vehicle and grants them special tax-deferred status. If the client withdraws funds prior to age 59½, the IRS will impose a 10% penalty on the withdrawal — similar to the penalty for premature withdrawals from qualified retirement plans and IRAs. The penalty only applies to withdrawals during the accumulation period, and not to contracts that are annuitized into a stream of income payments.

One of the key selling features of annuities is their tax-deferred status. Earnings in the contract grow tax-deferred, allowing the contractholder to “triple compound” interest — interest is earned on the initial investment, on past earnings in the contract, and on monies that would have been used to pay taxes on those earnings. By contrast, earnings from a taxable investment such as a mutual fund are taxable in the year they are distributed; if the investor chooses to reinvest, only the after-tax portion is available for compounding.

There are, however, tax disadvantages to an annuity as well. Earnings will be taxed when the account’s value is distributed to the contractholder — either as a withdrawal or as a series of periodic payments. All growth in an annuity contract’s value, regardless of its source, is taxed as ordinary income, not capital gains. By contrast, profits on investments in taxable securities like mutual funds, stocks, or bonds will be subject to more favorable capital gains treatment when the security is sold.

When comparing a tax-deferred annuity to other taxable alternatives, advisors should be careful to address both the tax advantages and disadvantages. Whether the annuity makes more sense from a tax perspective depends on:

• The investor’s current tax bracket
• The investor’s projected tax bracket when monies will be taken out
• The difference between the ordinary income tax rate and the capital gains rate
• The expected timeframe of the investment (the time earnings will grow tax-deferred)

Obviously, future changes in the tax code may also affect whether the annuity turns out to be the better investment.

Some advisors find the idea of placing a tax-deferred annuity within a tax-deferred retirement account to be unsuitable under any circumstance — the premise being that the beneficial tax status of the annuity is “wasted” when placed in a tax-deferred retirement account. By that same logic, investors should never purchase stocks or mutual funds in their IRAs, since the favorable capital gains treatment is also “wasted.” Few advisors would make that argument. The tax status of the investment outside a qualified retirement plan should not be a reason to disqualify including that investment in the plan. (The converse, however, may be true — it often makes sense to place less tax-advantaged investments into a retirement account.) There may be many reasons to not purchase a deferred annuity within a retirement account, but the “wasted tax benefit” argument is not one of them.

As investors grow older, there is less time to recoup losses, which leads to a natural progression from asset accumulation to wealth conservation. Advisors must pay careful attention to their client’s investment time horizon. Quite often that is based on age, but sometimes the time horizon is determined by other factors — parents saving for a child’s college education, saving for a down payment on a house, or the projected buy-out of a retiring partner’s business interest. While age is certainly an important factor in many investment decisions, advisors should inquire as to the purpose of the investment prior to making a recommendation.

There have been numerous complaints about sales of annuities to elderly clients. Placing a client into an investment with substantial surrender charges that may remain in force for most of the client’s remaining life expectancy is viewed very dimly by state insurance regulators. Florida imposes a suitability disclosure requirement when annuities are recommended to anyone age 65 or older, and FINRA imposes disclosure requirements on the sale of variable annuity contracts to clients of any age (both discussed in Chapter 6).

Advisors should take the time to understand the client’s tolerance to risk. Long-term (and profitable) relationships are built on mutual understanding. Advisors should determine whether their clients can sleep at night with the investment decisions they have made, and clients should be aware of the imprecise nature of investment analysis in a world of imperfect information.

All investments carry a degree of risk; some more pronounced than others. There are five general risks that investors should consider when making any investment:

We live in a litigious society. High-profile clients with presumable “deep pockets” are obvious targets for lawsuits. Some professions, such as medicine, are more susceptible to malpractice or other legal proceedings. These types of clients may want to consider investments that offer a greater level of protection from the claims of creditors. Sometimes the federal Bankruptcy Code provides this protection, other times it is provided by state laws. The most obvious examples of protected assets are the debtor’s homestead, retirement plans (including IRAs), life insurance, and annuities. The law offers this protection because certain assets are considered essential for the debtor and the debtor’s family to maintain at least a minimum level of financial well-being.

Florida generally offers unlimited creditor protection for proceeds of life insurance and annuity contracts. Other states may restrict that protection to amounts “reasonably necessary” for the support of the debtor and his or her dependents, some states will limit protection to a fixed dollar amount of each month’s annuity payments, and still others offer no protection at all.

In Florida, creditors of an annuity contractowner may not attach or garnish the cash values or other benefits of an annuity (or insurance policy), unless the contract was obtained for the benefit of the creditor. If the annuity company releases the cash value to the contractowner, however, the creditors may bring judgment against the contractholder for the released proceeds. The same applies to death benefits paid to the estate of the contractholder — once released to the estate, creditors can claim the death benefits. The estate is protected against creditor claims only as long as the annuity company holds the proceeds. Proceeds released to a designated beneficiary (other than the estate) cannot be attached by the contractholder’s creditors.

The Spendthrift Trust Clause

Contractholders can protect death benefits from the claims of the beneficiary’s creditors by having the annuity company hold the benefits. This provision is known as the spendthrift trust clause. More precisely, this provision shelters proceeds that have not yet been paid to a named beneficiary from the claims of either the beneficiary’s or the contract owner’s creditors.

The spendthrift clause does not protect proceeds paid in one lump sum — it only applies if the proceeds are held in trust by the insurer and paid to the beneficiary in installments over a period of time. Generally, the clause states that contract distributions payable to the beneficiary after the contractholder dies are not assignable or transferable and may not be attached in any way.

One factor many advisors fail to consider when making recommendations is the sophistication of the investor. Basic investments such as stocks and bonds may be relatively easy to understand, while packaged products such as mutual funds and annuities present a more complex situation. As the famed investor Warren Buffett says: “If you can’t pronounce it and can’t explain it, you probably shouldn’t invest in it.”

Some annuities, such as traditional fixed contracts, are very simple to understand: a guaranteed rate of return, fixed income payments for life, with relatively few fees. On the other hand, a variable annuity’s investment options, management fees, and varying values are more difficult to comprehend. The myriad moving parts of an equity indexed annuity — participation rates, spreads, caps, floors, and their complex interactions — can be extremely difficult to decipher for the general public and many financial professionals alike.

Regulatory organizations impose disclosure requirements on annuity salespersons with the intent to educate prospective clients as to the advantages and disadvantages of the product and allow the client to make an informed decision. But if the client is incapable of understanding the product’s features, then the product is, per se, an unsuitable investment for that client. If the sales pitch boils down to “trust me,” the product most likely will become a future problem for both the client and the agent.

On the other hand, a knowledgeable salesperson who can simplify a complex investment into everyday language opens a wider range of investment opportunities to clients. Just because an investment is complex or difficult to explain does not necessarily make it a bad investment. Advisors should simply be aware of the challenges of educating clients so that they understand the risks and benefits of the proposed product. In the case of complex products such as variable and indexed annuities, that educational process simply demands more time and patience — first to adequately educate themselves, and then to communicate that knowledge to their clients.

Annuities can be useful tools for estate planning purposes. In these cases, it is not uncommon for the client to be an estate or a trust, not an individual. Living trusts (inter vivos trusts) generally have the same investment objectives as regular individual clients: accumulation, conservation, distribution, and transfer. Estate clients and testamentary trusts will most likely focus on the latter two: distribution and transfer.

One estate planning reason to purchase an annuity is that the annuity’s benefits are available directly to the designated beneficiary upon the contractholder’s death — bypassing the delays and costs of the probate system. While this is true, other investments also can be structured to avoid probate (joint ownership, pay-on-death accounts, or ownership within a retirement plan or trust). So while annuities and life insurance policies will bypass probate, that alone is not a sufficient reason, by itself, to invest in annuities as opposed to other investments.

Fixed Deferred Annuities in Estate Planning

Fixed, deferred annuities provide three useful guarantees to the estate planner: guarantee of principal, guaranteed minimum rate of return, and guaranteed annuity payout factors. These guarantees provide a minimum return and minimize the client’s exposure to interest rate risk. Changes in the general level of interest rates will not affect the value of the annuity — the full value of the investment is available for withdrawal (subject, of course, to surrender charges).

Variable Annuities in Estate Planning

Variable deferred annuities do not offer such guarantees during the investor’s lifetime, but the minimum guaranteed death benefit could provide assurance to the investor’s heirs. Enhanced death benefits may provide additional comfort, locking in investment gains over the investor’s lifetime or providing a minimum rate of growth in the death benefit. This can be important when the amount passed to heirs is a key estate-planning goal. Older clients who are wary of putting “too much” into the stock market may find the guaranteed death benefit makes the decision to invest in equities more palatable.

Creditor Protection & Estate Planning

The creditor protection aspect of annuities may be a useful feature in the estate plan. Unlike other assets that might be attached by the deceased’s creditors, proceeds of an annuity contract are protected (to some degree) in most states. With some forethought, a person can also protect the value of the annuity from the creditors of the annuity’s beneficiary.

Providing Periodic Income to Heirs

One common goal of many estate plans is to provide periodic income to heirs — and annuities can provide an ideal way to achieve that goal. The estate plan may leave it to the estate’s executor to purchase immediate annuities to fulfill that desire upon the client’s death. Or a client can purchase a deferred annuity during his or her lifetime to accumulate and conserve wealth, with the intention that the contract be annuitized and payable to beneficiaries after death. Annuities are unique in that they are the only investment vehicles that can guarantee an income for the beneficiary’s lifetime. The greatest drawback is that once the periodic income payments begin, they typically must continue unmodified into the future — this lack of flexibility can be a disadvantage when annuities are compared with other alternatives.

Blended Families — Reconciling Competing Goals

Annuities can also be used to address a common estate planning dilemma: how best to invest estate assets to provide different types of benefits for different classes of beneficiaries. For example, a husband wants his estate to provide income for his surviving wife and pass remaining principal to his children by a previous marriage. The widow will want to maximize income production; the children will want to invest for capital appreciation.

A portion of the estate could be used to purchase an immediate annuity to provide an adequate income to the widow, while the balance is invested for growth. Investment setbacks in the growth-oriented assets will not affect the widow’s income, nor will income payments taken from the annuity affect the children’s portion. The key to this strategy’s success depends on how large a portion of the estate must be paid to the annuity company to provide an adequate income — and that, in turn, depends on the age of the income-receiving beneficiary. Annuities will pay a higher periodic payment to older beneficiaries than younger ones, all other factors being equal.

Lifetime Gifts & The Stretch Annuity

One prime objection many people have to giving substantial gifts during their lifetimes is “I might need that money.” If the client and his or her spouse have a guaranteed lifetime income, that objection may be more easily overcome — the client could transfer more of the estate’s value during his or her lifetime, at a lower tax and administrative cost, and perhaps with greater emotional satisfaction. The various enhanced living benefits (GMAB, GMIB, and GMWB) may also assuage the investor’s need for lifetime income and make a program of lifetime gifts more attractive.

Annuities also provide a mechanism to defer taxes even after death. Periodic annuity payments are only partially taxable — each payment is effectively part taxable income and part tax-free return of principal (the “exclusion ratio”). Meanwhile, earnings in the account continue to grow tax-deferred during the annuity period. That tax deferral can be extended past death by use of a “stretch annuity” — an annuity contract that sets the beneficiary designation such that eventual payments must be paid out to beneficiaries in the form of periodic annuity payments (not lump sum withdrawals), resulting in continued tax deferral of earnings long after the investor’s death. In the case of spousal beneficiaries, the surviving spouse can “step into the shoes” of the deceased investor and name new beneficiaries, extending the tax deferral period even longer. As noted, this use of the beneficiary designation can also act as a “spendthrift clause” to protect the beneficiary from creditors’ claims. In a way, the annuity operates like a trust, limiting access to the underlying assets.