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A similar product development pattern has emerged with annuities.
Previously, the proliferation of fixed rate, indexed, and variable accumulation products shifted the focus of annuities from distribution vehicles to wealth accumulation vehicles. In what appears to be another example of everything old being new again, however, annuities are increasingly being positioned as an attractive tool for retirement and qualified plan distribution planning.
Today, the average life expectancies for a 65-year-old male and 65-year-old female are nearly 81 and 85, respectively. A healthy couple can expect to enjoy 20 or 30 years in retirement, but the definition of retirement has changed. Many people now retire in their 50s and 60s and they are not necessarily looking to amass money to live on forever. Many have multiple careers well into their senior years and want to create the financial flexibility to continue an active lifestyle. Now there are annuity products that provide the opportunity for both wealth accumulation and certainty of income for life. The concept of surrendering one's hard-earned wealth to an insurance company in exchange for a fixed annuity for life has been reconsidered. The old annuity dog has learned some new tricks.
Annuities are long-term, tax-deferred vehicles designed for retirement purposes. Guarantees are based on the claims paying ability of the issuer. Withdrawals made prior to age 59 1/2 are subject to a 10% IRS penalty tax and surrender charges may apply. Gains from tax-deferred investments are taxable as ordinary income upon withdrawal.
The essence of financial planning is providing a menu of strategies to support clients' objectives and prerogatives. A brief overview of the various annuity products is useful in assessing the role annuities can play in financial and retirement planning strategies.
Deferred Fixed Annuities
The attraction of deferred fixed annuities for most clients is the guaranteed return of principal and tax deferral. While similar to CDs1 offered through banks, fixed annuities offer limited guarantees after the first year and require surrender charges that usually decline during the length of the holding period.
Commissions are paid to the agent by the issuing insurance company for the sale of the contract. The owner may incur insurance charges and surrender fees, which compensate the distributor for early or excessive withdrawals. When a deferred annuity is placed in the payout mode, or converted to an immediate annuity, the tax-deferred gain in value is spread over the years of the distribution. The minimum time period to distribute deferred gains is 60 months. Gains are taxed as ordinary income upon withdrawal. This effective "income averaging" concept may be a useful financial planning tool.
Deferred Index Annuities
The appeal of deferred index annuities lies primarily in the ability to participate in the upside potential of the equities market combined with a guarantee return of principal and a minimum contractual growth rate. Typically, there is a participation rate set to an equity index -- such as the S&P 500 -- for measuring growth. Any market gains in deferred index annuities may be forfeited if certain conditions are not met. The contract requires the owner to hold the contract to an established date, which may be as long as 10 years. Index participation may be reset quarterly, annually, or periodically by the insurer. These are long-term contracts and may not provide desired liquidity for some clients.
Variable Annuities
Variable annuities may provide the greatest growth opportunity, but also pose additional investment risk through accumulation unit sub-accounts. They can also carry higher expense charges and distribution costs. (See chart on page 46 for some of the benefits contained within a variable annuity.) The primary attraction of variable annuities is the opportunity to participate in the equity markets. This includes having multiple equity managers coordinating the sub-accounts within the product. Some annuities offer as many as 30 sub-accounts and up to a dozen different investment management firms to coordinate management. An annuity sponsor may offer several riders, at an additional fee, that provide conditional guarantees coordinated through annuity or withdrawal provisions. The investment returns and principal value of the sub-accounts will fluctuate and it is possible to lose money.
The investment returns and principal value of the available sub-account portfolios will fluctuate so that the value of an investors' units, when redeemed, may be worth more or less than their original value.
GMIB and GWAB Riders
I recently lunched with an analyst from a large broker-dealer who told me more than 80% of his firm's new variable annuity business provided a Guaranteed Minimum Income Benefit (GMIB) or a Guaranteed Minimum Withdraw Benefit (GMWB) rider.
A GMIB rider gives the owner of a tax-deferred accumulation variable annuity contract the option of taking a distribution of the accumulated market value of the contract at a future point in time, or receiving a distribution from a guaranteed benefit base. The benefit base is usually defined as the purchase money plus a minimum growth factor for a defined number of years. The minimum growth rate varies with the issuer. I have reviewed annuities with minimum income benefit projections of 5%, 6%, and 7% growth for the benefit base.
Additionally, some issuers permit the benefit base to be increased with a quarterly or annual ratchet based on an industry index as a third option to value the contract for future benefits.
One advantage of this strategy is that the benefit base may be higher than the market value at a future time, when the purchaser takes a withdrawal for income or receives benefits. The annuitant should be aware that the contract issuer may restrict a full redemption of the contract under the GMIB if the value under this option is greater than the alternative market value. With respect to distribution planning, however, this may be appropriate for a small portion of a retirement accumulation portfolio. In my opinion, funds invested in this strategy should not exceed 25% of client assets. This is not an ideal solution for everyone because of the potential liquidity restrictions of most GMIB riders.
A GMWB places a different focus on variable annuity valuation. Although growth is important, this rider establishes a minimum withdrawal rate available for the annuitant's current income needs. Many riders provide a 7% guaranteed minimum withdrawal rate as a portion of a client retirement portfolio. Theoretically, if the market performed at zero growth for the next 14 years, clients could take a 7% withdrawal from their funds and the value of their accounts would fall to zero. Alternatively, if the funds were invested in the variable annuity with a net growth rate of 7%, the valuation should remain constant. If the market value of the contract exceeded a net rate of 7% annually, the contract would provide income and growth.
Some riders, such as the GMIB and GMWB, may be part of an existing contract, while others may carry additional fees, charges, or restrictions.
Charges
A variable annuity contract has greater internal mortality and expense charges than an alternative investment, generally 2% to 2.5% higher, depending on the insurer. This provides retirement income predictability for the next 15 years for most clients and enables them to participate in the long-term potential for higher portfolio returns usually associated with an equity portfolio -- in lieu of a traditional fixed income portfolio. With some insurers, the benefit base may be adjusted upward if the sub-accounts perform well. This is an important planning consideration for those who expect to live longer and hope to have their investments keep pace with inflation.
Our internal market research indicates that distribution planning is the next threshold to be embraced by consumers and product sponsors alike. We have seen the introduction of an indexed GMWB designed to provide a fixed income for life with the provision that the rate increases with the withdrawal age if the annuitant waits longer to start taking benefits. Also, once the annuitant initiates a systematic withdrawal, there is a periodic increase in the benefit provided to compensate for inflation. I believe the competitive nature of the insurance industry will provide future product enhancements to create a marketing advantage or competitive edge.
The most important issue is that all of the assumptions we make to establish the financial planning picture today can change dramatically before we arrive at the planning horizon. The foundation for any financial planning endeavor therefore requires flexibility. Many of the variable annuity products available today provide flexibility via the GMIB and GMWB riders. From a financial planning perspective, the modern variable annuity product enables advisors to provide a money purchase strategy that can determine distribution value and form -- a distinct advantage in uncertain times.
Examples
Here are three examples of how our firm has used variable annuities with these riders.We suggested a variable annuity with a GMIB rider to protect assets and potentially provide an income stream for the 50-year-old spouse of a 60-year-old client who planned to work for another 10 years. A previous financial reversal caused the client to lose a portion of his retirement nest egg. He was concerned about equity market volatility and sought an appropriate strategy to build greater retirement security. We suggested approximately 15% of his qualified funds be placed in the annuity with a 7% growth factor attributable to the GMIB. We believed if he needed to take a systematic withdrawal at the end of the contractual 10-year option period to secure the GMIB benefit base value, the income stream could be supportive for both him and his younger spouse. The GMIB provided a degree of certainty for the invested funds and would potentially provide higher returns, if invested in equities, than if invested strictly in fixed income.
Another case dealt exclusively with qualified plan distribution planning. The client, in her late 60s, was retired and expected to live into her late 90s. She wanted to receive a 7% income stream from a GMWB and still have the opportunity to participate in potential long-term equity appreciation. Although she could have invested in equities and taken a systematic distribution to achieve a similar income result, the variable annuity provided the death benefit guarantees and the opportunity for an adjusted benefit base should the market perform as hoped.
A third strategy was suggested to hedge gains within an equity portfolio. The client was invested heavily in equities and had enjoyed a nice run up in value within a relatively short time. We suggested that he trim some of the positions in his IRA portfolio and direct some of the gains into a variable annuity contract with a GMIB rider. If the market value of his IRA were to continue to go up, the additional cost for this strategy would be the additional expenses of the variable annuity contract. If the market were to go down, the GMIB valuation would protect the initial investment in this segment of his portfolio.
Financial planning requires that we, as advisors, deliver products supporting the guarantees that form the foundation of our client relationships and trust. Although there are higher costs associated with variable annuities, at the end of the day, these strategies offer insurance to support a desired objective. Many of us have grown up in the insurance business. Risk is a four-letter word, but not necessarily a bad one if managed intelligently. The annuity marketplace has taken broad steps to move us closer to providing the guarantees we have promised in the past and will continue to provide in the future.
Steven Leshner, MBA, CLU, ChFC, is a principal of The Commonwealth Investment Management Group. He is a registered representative with Linsco Private Ledger (LPL), an independent broker-dealer.Footnote
1. CDs are FDIC-insured and offer a fixed rate of return if held to maturity.
