Over the past decade, living benefits have been the primary selling point for variable annuities. That’s what has driven most of the VA sales at Nationwide Financial.
We expect that will continue to be the case because living benefits can be a great tool to help clients address the income replacement challenge in retirement. However, advisors shouldn’t forget to help clients understand that a VA can bring other powerful benefits to a portfolio beyond living benefits.
With interest rates at historically low levels and market volatility an ongoing reality, clients are looking for investment solutions that can position them for market gains, while guarding against market down-turns. This growth is critical as clients plan for inflation, rising healthcare costs and potential tax increases. VAs may be able to help address these challenges, and not only because of the value a living benefit rider can provide.
When talking to clients about whether or not a VA is the right fit for their portfolio, an important part of the discussion should involve the added value of features like tax deferral, legacy planning and the option to create income through annuitization. After you help clients understand the value of the guaranteed income provided by a living benefit rider, here are some other important points to touch upon:
With the possibility of increased tax rates in the near future, the industry has an opportunity to highlight a benefit that addresses a need that is likely to become a growing focus for clients. When taxes were at near historic lows and higher living benefit rates were available, tax deferral may not have been top of mind for many buyers. Now you may find this to be a much stronger selling point.
First, make sure clients understand the potential changes that may affect the tax landscape in the near future:1
- Long-term capital gains rates are scheduled to rise to 20% from 15% for most taxpayers.
- Tax on dividend income may go from 15 percent to ordinary income rates, which could be as high as 39.6%.
- A 3.8% Medicare investment earnings surtax is likely to affect those with high incomes and investment earnings.
- Expiration of Bush-era tax cuts will impact the top four marginal brackets and eliminate the 10% bracket—meaning higher taxes for virtually everyone.
- The phase-out of itemized deductions for high income earners is set to return in 2013.
Next, help clients visualize how a VA may be able to enhance their portfolio’s tax position:
- VAs allow money to accumulate tax-deferred until withdrawals begin and may provide liquidity while the money is accumulating.
- Clients can convert funds or investments that are currently taxable like CDs, money market funds or mutual funds into a tax-deferred variable annuity. (Note: Fees may be incurred by transferring money to an annuity.)
- Owners of VAs can exchange underlying investment options from multiple fund families within subaccounts of an annuity and may not have a tax liability or transaction costs.
- There are currently no regulatory limits on contributions to variable annuities.
At a time when life expectancies are soaring, many clients are struggling to balance the need to plan for an unknown period of income with their hopes to pass an inheritance along to their family. Variable annuities can help clients meet both of these goals because money in the annuity can be tapped for income if needed or left to heirs with a VA’s death benefit feature.
Some VAs offer one-year, step-up death benefit protection, which allows owners to lock-in market gains when the market is up, preserving pay-out levels for beneficiaries during down markets. This lets clients grow money intended for heirs because the VA’s insurance protection may provide a backstop against short-term market dips.
The Annuitization Option
Beyond the income from a living benefit rider, annuities also can be used to provide a tax-advantaged stream of income through annuitization at no additional cost to the customer. Annuitization may make sense for three reasons: first because it can provide a lifetime income guarantee, which can be very attractive in the face of uncertain longevity.
Second, annuitization may provide better tax treatment on income than a living benefit because the payments are subject to an exclusion ratio. In other words, the full amount of the benefit may not be subject to taxation because a portion of each payment is a return of the owner’s cost basis. Lastly, clients may create lifetime income with a smaller initial investment than is required to do so with a living benefit rider.
It’s important to help clients understand that, while the benefits of annuitization may provide a good solution for income needs, they come with a trade-off. Annuitization stops market growth and may prevent access to liquidity, although some VAs provide attractive options to address each of these trade-offs through variable annuitization and liquidity features.
Another way a variable annuity without living benefits may enhance a portfolio is by providing access to alternative investments.2 Annuities that offer alternative investment options have gained traction in the marketplace in recent years as investors look for more options in a volatile equity market.
A winning combination
Nationwide is in the living benefits business to stay, but we’ll continue to encourage advisors to make sure they are helping their clients understand the full value of a VA, beyond simply having a living benefit rider. It’s the combination of these benefits that may make a VA such a strong fit for so many portfolios.
1 Journal of Accountancy, November 2012
2 An Alternative investment is an investment that is not one of the three traditional asset types (stocks, bonds and cash). Alternative investments include hedge funds, managed futures, real estate, commodities and derivatives contracts.