Chapter 4 — Investors & Objectives (continued)

Annuities held within a trust, or annuity distributions paid into a trust, can be problematic. Advisors should be aware of the adverse consequences when mixing annuities and trusts. The tax consequences of purchasing an annuity in a trust account were discussed in detail in Chapter 2. Advisors should resist the urge to put annuities within a trust out of the simple belief that “everything should be held in the trust” to aid estate management and disposition.

Often, a contractholder will want to name his or her trust as the beneficiary of the annuity. In these cases, the annuity must be distributed under the “five-year rule” discussed in Chapter 2. By contrast, an annuity payable directly to a beneficiary (outside of a trust arrangement) can be paid out over the beneficiary’s lifetime — which provides additional tax-deferral under the “stretch annuity” principle. Presumably, distributions payable to a trust serve some other estate planning goal such as estate liquidity or greater control over the ultimate distribution to beneficiaries. In the absence of other valid planning reasons, the investor’s estate plan may be better served by designating the ultimate beneficiary, rather than a trust, to receive the annuity proceeds.

Problems also arise when annuities are owned by a trust. In these cases, the owner of the trust cannot be the “measuring life,” as the trust itself has an indefinite lifespan. This means that all trust-owned annuities must be “annuitant-driven” (a measuring life other than the owner’s dictates when annuity payments begin). There are important distinctions between “annuitant-driven” and “owner-driven” annuities — and annuitant-driven annuities are more susceptible to unintended consequences and adverse tax treatment.

Charitable organizations represent a large market for annuities. One common estate and tax planning tool is the charitable remainder trust (CRT). CRTs are irrevocable trusts that provide for and maintain two sets of beneficiaries:

• Income beneficiaries — the investor who funds the trust (and, if married, a spouse), who receive a set percentage of income for their lifetime
• Charitable beneficiaries — the charity(s) named by the grantor, who receive the principal of the trust after the income beneficiaries pass away

Because of the two types of beneficiaries, CRTs are a type of “split interest” trust. While a CRT is irrevocable, the grantor (and spouse or other person) may change the charitable beneficiaries during their lifetimes. Under certain conditions, the grantor may even serve as trustee of the CRT and maintain control of the investments inside.

Tax Advantages of CRTs

CRTs offer powerful tax-saving advantages. The most obvious is a charitable income tax deduction on the donor’s tax return. The size of the deduction depends on the present value of the amount the charity can expect to receive — which is related to the current fair market value of the asset, the size of the income payout percentage selected by the grantor, the expected length of the payout period, discounted by an IRS-approved interest rate. There are limitations on the size of the income tax deduction that can be taken each year based on the grantor’s taxable income and the type of asset donated. The full value of the charitable donation is deductible for gift and estate tax purposes.

Because the assets in the trust are destined for a charity, CRTs do not pay any capital gains taxes. For this reason, CRTs are ideal for assets like stocks or property with a low cost basis but highly appreciated value.

The amount of income to come out of the CRT depends on the payout percentage the grantor chooses and the income the assets generate inside the CRT. The IRS requires the CRT to distribute at least 5% of the net fair market value of its assets. Payouts in excess of 10% each year can be problematic — the higher the payout percentage, the less available to the charity (and therefore a lower charitable tax deduction), and the principal inside the trust may be reduced quickly.

For clients concerned with leaving assets to their children, a portion of the income payments can be used to purchase a life insurance policy — payable to the children or others to replace the value of the assets placed in the CRT — typically done through a separate “wealth replacement trust.”

CRAT vs. CRUT

Corporations (or other business entities) may find annuities helpful in meeting their obligations. The most common corporate use of annuities is to fund and distribute pension payments to retirees. This was the initial reason issuers developed group annuities. Prior to the development of modern group annuities in the early 20th century, pension plans were pay-as-you-go schemes, primarily benefiting corporate executives. Group annuities allowed corporations, in exchange for premium payments, to shift that responsibility as well as the investment and mortality risk to insurance companies — also allowing for the expansion of retirement benefits to more rank-and-file employees.

Qualified Plans

When federal pension laws were reorganized under ERISA in 1974, traditional pension plans were reclassified as defined benefit plans. ERISA mandates that defined benefit plans purchase insurance coverage from the Pension Benefit Guaranty Board and imposes greater accounting and funding requirements. Plans that purchase an annuity to guarantee funding are exempted from many of these additional costs — as a result, ERISA motivated many defined benefit plans to become “annuity purchase plans,” creating a large market for group annuities.

As life expectancies lengthened, the legacy costs promised to retirees increased. In the last decades of the 20th century, many companies shifted from defined benefit plans to defined contribution plans — instead of guaranteeing a fixed benefit to retirees, companies chose to guarantee a fixed contribution to the pension fund. Over time, individually tailored plans such as 401(k) plans became more popular, with monies deposited into an employee’s individual account and the employee directing the fund’s investments. (Tax Sheltered Annuities serve the same role for non-profit employers.) All defined contribution plans shift the investment risk from the employer to the employee. Annuities, especially variable annuities with their separate accounts, are commonly used to meet the accumulation needs of the defined contribution plan.

A 1982 amendment to ERISA mandates that retirement benefits paid to married workers must be paid in the form of a joint annuity, unless the worker’s spouse waives that requirement in writing. This requirement — designed to protect widows and widowers from having their income cut due to the death of the covered worker — encourages the use of commercial annuities as a distribution vehicle for retirement benefits.

Separate accounts holding the investment portfolios of a variable annuity are typically registered with the SEC under the Investment Company Act. Some group variable annuity contracts are exempt from that registration requirement — specifically, group variable annuities sold exclusively to qualified retirement plans covering at least 25 employees in which the employees make no contribution to the purchase of the annuity need not register.

Non-Qualified Plans

While qualified retirement plans represent a large market for annuities, corporations can also use annuities to fund non-qualified retirement programs, such as deferred compensation plans. Non-qualified plans do not need to meet the broad participation standards of ERISA and can be targeted to a select group of “key” employees. Non-qualified plans can be an inducement when hiring new personnel, or they can be used as “golden handcuffs” to retain employees who are critical to the company’s success.

In a non-qualified deferred compensation plan, the employee will forgo some of his or her current, taxable compensation in return for a promise of greater retirement benefits. The idea is to defer paying taxes on today’s income and receive it in the future, presumably when the retiree is in a lower tax bracket. The employer can use the deferred compensation to purchase an annuity contract to fund and pay the promised retirement benefits.