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Choosing an Annuity in 2014 [CPA Journal, The](CPA Journal, The Via Acquire Media NewsEdge) The Effect of Low Interest Rates and Higher Tax Rates This author's May 2012 CPA Journal article, "Choosing an Annuity: What Accountants Need to Know," remains a comprehensive primer on the various types of annuities available to individuals and discusses in detail estate and income tax treatments of those annuities. This current article will address how recent events-primarily the reduction in the level of interest rates and changes in individual income tax rateshave made some annuity products no longer attractive, while encouraging some companies to create new types of annuities that may be of interest to certain individuals, though not for their traditional purpose of generating retirement income. A Brief Review of Annuity Types Annuities are special kinds of insurance contracts that have been used in the past primarily to create retirement income for individuals. They remain one of the very few ways that an individual can receive a check for life. Understanding the various types of annuities and their features can be difficult, because many of these contracts' features are very complex. Nevertheless, when correctly used, annuities can play an important part in individuals' financial planning. Until recently, choosing an annuity was simply a matter of determining whether one needed income now or in the future. If clients needed income right now, a financial planner would advise them to consider immediate annuities. Upon purchasing an immediate annuity, an individual makes an initial cash deposit with the annuity company and then receives monthly income distributions, either over a certain period or for life. Often, the benefit continues after an initial annuitant dies, as with husband-and-wife survivor annuities. What if individuals need income in the future? A financial planner would counsel them to consider deferred annuities. Upon purchasing a deferred annuity, a client makes an initial cash deposit with the annuity company (or multiple deposits over time), and then receives a stream of monthly income distributions that begin at a selected date in the future. [There is another class of deferred annuity beyond the scope of this article, the Multiple-Year Guaranteed Annuity (MYGA), which typically pays a certain percentage of the amount on deposit for terms ranging from 3 to 10 years. The client has the options of either collecting this "interest5' distribution yearly or leaving it on deposit continuing to earn tax-deferred interest. MYGAs are often used as bond substitutes, and when they mature they are frequently exchanged pursuant to Internal Revenue Code (IRC) section 1035 into a fixed or variable annuity. At this time, the crediting rates of "interest" on this type of annuity are at historically low levels, which has diminished interest in this product.] During the period from the date of deposit until the date of distribution, the deposited funds accrue earnings and grow (hopefully), but the taxes on this growth are deferred until distributions are made from the annuity. For most deferred annuities, the earnings on the invested funds accrue at a rate set by the annuity company determined solely by its discretion. But some fixed annuities took this feature a step further and tied the growth of the deposit to a rate that reflected the performance of an objective investment index, such as the Standard and Poor's (S&P) 500. Deferred annuities of both types are still available in the market today, but the fixed annuities whose crediting rate is based on a percentage return set by the annuity company now provide very low rates of return, reflecting the general market level of interest rates. The deferred annuities based on the performance of an index, such as the S&P 500 or another equity market index, are also available today and have become relatively more popular due to the recent positive performance of the equity markets. Variable annuities are yet another version of deferred annuities. In the case of variable annuities, the method of determining the performance of the deposited funds is completely different. With these contracts, the cash deposited into the annuity is invested in various individual subaccounts that represent investments in equity and fixed-income mutual funds chosen by the annuitant. A few years ago, retirees and soon-tobe retirees found these variable annuities to be very attractive, because they were able to add certain riders to these contracts that guaranteed lifetime income for the annuitant regardless of the value and performance of the subaccount investments held inside the annuity. These riders were called "living benefif ' riders. Theoretically, the subaccounts could lose all their value, and yet the annuity company would be obligated to pay out a check for life, based largely on a formula of how much money was initially invested. In order for the annuity company to guarantee a certain level of lifetime income, however, it had to hedge the investments that clients made in their sub-accounts. As a result, the choice of investments was often limited to a small universe of funds that the annuity company believed it could efficiently hedge. In some cases, in order to keep the hedging process as efficient as possible, the annuity company limited the percentage of equity investment subaccounts that clients could invest in or retained the unilateral right to transfer funds out of equity investment subaccounts into fixed income subaccounts under certain adverse equity market conditions. In addition, the charge for the living benefit rider could be substantial. Variable annuities with living benefit riders are still available in the market today, but their features and guarantees have been pared back substantially and their fees are still relatively high, so they are not as popular as they once were. The Annuity Environment Today: Low Interest Rates The general level of interest rates has fallen to a very low level, as a result of Federal Reserve policy to stimulate the economy. This has had the effect of either causing annuity companies to exit the market for immediate annuities or to price their immediate annuity products with very low, unattractive returns, thus dampening sales of immediate annuities. This has happened because a major portion of annuity companies' profits came from investing the funds their customers put on deposit with them in U.S. government securities-the main asset class that annuity companies are allowed to invest in-whose yields are at historically low levels. For potential annuity customers, this means that the returns they can expect to receive from immediate annuities at this time are extremely low. These rates are generally unattractive for anyone except older individuals, for whom mortality issues enter into the pricing equation and make the return at the very least competitive when compared to fixed-income returns. In other words, the market for immediate annuities has become much less attractive-except for those age 75 or older, because their reduced life expectancy permits the annuity company to make regular distributions higher than comparable bond market returns. The Annuity Environment Today: Higher Tax Rates Personal income tax rates have increased recently, and high-income taxpayers now face a federal net investment income tax (NET) on unearned income. In particular, maximum long-term capital gains rates have increased at the federal level from 15% to 20% (plus the 3.8% NET, if applicable) and the top federal marginal income tax rate has risen to 39.6%. For those individuals who are not at the maximum marginal income tax rate, however, the difference between the long-term capital gains rate and the ordinary income tax rate is much narrower than in the past. As a result, the value of tax deferral, which is provided by deferred annuities, is much more attractive now, even if all of the proceeds that are eventually distributed from such annuities are subject to tax at ordinary income tax rates. Several annuity companies have introduced new products to take advantage of today's high personal income tax rates. Instead of being aimed at the retirement market, these products are being targeted as investments. In fact, these annuities are known colloquially as "investment-only variable annuities" (IOVA). Essentially, annuity companies have taken their standard form of variable annuity contract and stripped it of its expensive living benefit riders. Removing these riders means that the annuity companies no longer have to hedge the investments made by their annuitants, because they are not guaranteeing any level of future withdrawal payments. This has permitted the companies to offer a far wider range of investment subaccounts than they did previously. Generally these annuities provide that the client can invest in a wide range of asset classes (including, in some cases, alternative investments) and can be as aggressive in their allocation between equities and fixed income subaccounts they want. While investing in the IOVA does not mitigate the market risk inherent in both equity and fixed-income investments, it does under certain circumstances make the potential for net returns greater than if the individual had not invested in the IOVA and had paid capital gains tax rates over the same investment period. While variable annuities have traditionally been distinguished by high fees that buttress the annuity company's guarantees, the fees in these IOVA contracts are much lower and competitive with those charged by more traditional investment vehicles, such as brokerage accounts. Some annuity companies use calculators on their websites to demonstrate that, with certain assumed levels of subaccount performance and at certain assumed holding periods (generally, the longer the better), an individual could actually be better off on an after-tax basis by investing using an IOVA as compared to more traditional investments, such as mutual funds held in brokerage accounts. In short, the value of the tax deferral can overcome the effect of the ordinary income tax rate the annuitant would have to pay on distributions from the IOVA. Like all investments, the value of these subaccounts can go down as well as up, so it is probably best to view investments in such annuities as long-term investments, not shortterm trading vehicles. This new type of variable annuity can be used in a number of ways unrelated to generating retirement income. For example, they can be an attractive stand-alone investment for a portion of a client's wealth if the individual is in their late 40s or 50s and does not anticipate taking any funds out prior to age 59 'A (which would cause an excise tax to be charged on distributions, in addition to the income tax that would be due). Depending upon the performance of their subaccount investments, the advantage of tax-deferred compounding could be substantial. Second, this new type of variable annuity could be used by complex trusts to shelter income on investments that are anticipated to be held in trust for significant periods of time. The annuity can be owned by the trust and yet be tax deferred if the trust benefits a natural person. [See IRC section 72(uXl), which generally voids tax deferral for an annuity held by a non-person but is modified by the following text of the statute: "For purposes of this paragraph, holding by a trust or other entity as an agent for a natural person shall not be taken into account."] Considering how quickly earnings in a complex trust can reach the highest marginal tax rate, this could be an attractive investment choice for at least some of the funds held in trust. Another consideration in using this new type of variable annuity is that, under certain circumstances, they can continue to provide tax deferral to trust beneficiaries, even for annuities that have been distributed from a trust. Many trusts mandate the distribution of principal when beneficiaries reach a certain age, which would terminate the protection provided by the trust against creditors. But, in some cases, if the trust held an IOVA, with a trust beneficiary as the annuitant, the trustee could distribute the annuity contract "in kind" without liquidating it. Doing so would provide continued tax deferral and, depending on the jurisdiction, some protection from creditors [e.g., New York Insurance Law 3212(d); the protection is available, but not iron-clad, and the annuity may be subject to execution for such amounts that seem "just and proper to the court"]. This particular strategy is subject to a number of complex mies, and it is advisable that financial planners and their clients confer with the annuity company directly before purchasing any annuity to make sure that the desired benefit is both available and properly structured. A final consideration is that all annuities, including IOVAs, are considered insurance contracts under the tax code, and the cash value in an annuity contract can be ported or exchanged into other types of annuity contracts (but not life insurance contracts) free of tax, pursuant to IRC section 1035. This can be a valuable feature when, after a number of years of growth in a variable annuity, an individual elects to begin receiving income. The value of the subaccounts can then be annuitized, either with the same annuity company providing the variable annuity or with another annuity company the client selects, if its product is more attractive. Difficult Conditions CPA financial advisors can help their clients understand whether annuities might be appropriate investments for them and help them choose the appropriate annuity. Choosing the right annuity is more difficult than ever, as a result of the present conditions in the capital markets. Clients are also looking to their accountants to help them manage their tax liabilities, and in this regard CPAs should be familiar with newly available variable annuity products that might be very helpful in accomplishing such objectives. While annuity products have been traditionally used to generate retirement income, new products, such as the IOVA, are now available to defer taxes in a number of situations not directly related to retirement. Bruce L. Resnik, JD, CPA/PFS, is a senior financial advisor with Summit Financial Resources, Inc., New York, N.Y., and a registered representative with Summit Equities, Inc., member FINRA/SIPC. For more information, see www.bruceresnik.com. (c) 2014 New York State Society of Certified Public Accountants |