The current meltdown in the stock market has had mixed impact on annuities.  As mentioned in this retirement blog, Variable annuities “vary in value” and have suffered sizeable losses during the market meltdown.   Fixed annuities, on the other hand, have avoided losses because they are guaranteed not to lose value if the market crater. Let look over the horizon and speculate about what the future holds for annuities.

The primary advantage of annuities is the deferral of income taxes.  While this feature has not always been center stage, the anticipated increase in future income taxes now highlights this attractive advantage and has spawned a new interest in fixed annuities. If the new Congress and Administration provide incentives for “saving” rather than “consuming”, tax deferred annuities will gain market share from bank CDs and other safe money alternatives because no taxes are paid on earnings until they are actually withdrawn.

The guaranteed lifetime income features of variable and fixed annuities have added substantially to their demand as retirement planning tools.  The retirement-minded have been able to roll-over qualified accounts into annuities and secure a guarantee lifetime income that remains under their control.  The value of the annuity converted to a lifetime income is guaranteed to grow at a stipulated rate, generally from 5% to 8%, even if the market loses ground.  This permits a known minimum lifetime income to be “locked up” while maintaining flexibility if the money is later needed for other purposes.  Just as insurance companies offer risk protection for health, life and property, retirees can now buy protection for their greatest fear: outliving their retirement money.  The development of lifetime income guarantees should prove to be a substantial demand-builder for annuities as the population ages, especially if the current economic and financial uncertainty persists.

While tax deferral and the ability to secure protection for longevity risk will no doubt bolster the demand for annuities in the future, there are other forces working that will have the opposite effect.  The same forces are not expected to affect variable and fixed annuities equally; thus, let’s discuss each separately.

Variable annuities are essentially mutual funds offering full market participation – both upside and downside – with tax-deferral but without capital gains treatment.  They also feature riders, generally for a fee, that offer lifetime income and good death benefits.  Plus, variable annuities permit wide latitude in choosing and changing sub-accounts. The recent market’s negative returns have been exacerbated by the steep fees on VAs and as a result demand has turned anemic.  Accordingly, variable annuities will most likely remain out of favor as retirement investments until the market’s future direction is crystal clear.

By avoiding losses in the current market meltdown, fixed annuities, including index-linked annuities, have emerged as a safe haven for retirement money.  Notwithstanding the avoidance of losses by fixed-index linked annuities, the SEC has proposed Rule 151(A) that will classify some or all fixed index-linked annuities as securities.  Should 151(A) become final many independent producers will simply stop offering indexed annuities because they do not want the hassle of becoming securities licensed and dealing with the hassles of becoming securities licensed or registered. Accordingly, is Rule 151(A) becomes law fixed index-linked annuities may be harder to find by the retirement-minded. This is the classic case of the government trying to help but actually hurting those that could most benefit from safety and tax deferral: the retired.   Of course, traditional fixed annuities which offer a set rate for one or more years will still be available as a safe place for tax deferral.

No doubt there will emerge innovative fixed annuities that avoid Rule 151(A) yet offer substitutes for fixed rates without relying on market indexes.  For example, an inflation-linked fixed annuity would offer retirees stable purchasing power without the involvement of market risks. What’s more, fixed annuities with annual inflation adjustment would mirror current Social Security benefits and could add considerable income stability in retirement.  The inflation-hedge feature is appearing with more frequency in annuities, albeit as a rider that commands a fee.

While there remain pluses and minuses, variable annuities are likely to continuing fading into the background as retirement investments simply because of market risk, high fees and poor performance.  While tax deferral, guaranteed lifetime income and death benefits are favorable, these continue to develop inside fixed annuities without the threat of market risks or the levy of high explicit fees.  The recent variable annuity losses will likely spawn further taint on their acceptance as retirement investments.

Fixed annuities on the other hand, should rise in popularity because they offer safety, deferral of anticipated higher income taxes and feature lifetime income options.  If the current generation of retirement-bound boomers and retirees are permanently jaded by the recent market meltdown, the acceptance of traditional fixed annuities could surge in an environment of rising taxes and low fixed rates.  This is especially true if the design changes to promote stable purchasing power during retirement.  The developing features of fixed annuities, low fixed rates from banks, expected higher taxes, and a risk-averse aging population augurs well for fixed annuities.

Shelby Smith, Ph.D.
December 2008
TheRetirementPros.com

Related Topics: Tapping Into Your 401(k) Money Before Retirement (Video Seminar & eReport), Fixed Annuities: A Good Option for Bad Times (Video Seminar).

As I mentioned in my Retirement Blog, Aging Americans face the major risk of needing convalescent care at some point in their lifetime.  Roughly 70% of those aged 65 and over can expect to need long-term convalescent care, and the probability increases dramatically with age.  If needed, the expense is staggering and can amount to as much as $155,000 annual for full-time in-home care.  How can this real risk be addressed using the hard-to-exit-from-with-full-value two-tier annuity?

Many two-tier annuity owners find attractive a linked-benefit insurance policy that provides the following all-in-one protection:

1. life insurance that pays a tax-free benefits to beneficiaries at the death of the owner;
2. long term care (LTC) expenses up to a multiple of seven-times the initial death benefit;
3. a residual benefit of 10% of initial death benefit even if the maximum LTC benefits are paid for convalescent care;
4. a guaranteed no-questions-asked money back return of the initial premium if the owner wants to cancel the policy at any time.  What’s more, to qualify the two-tier annuity owner only needs to answer eight questions as “no” and spend 30 minutes in a phone interview with an underwriter.  The policy is then issued in less than ten days.  Let’s look at an example.

Suppose Edna Algonquin, age 72, has $200,000 in a two-tier annuity.  The annuity was purchased “just in case she needed “rainy day money” to cover a medical emergency.  Unfortunately, she was not fully aware that a lump-sum withdrawal or transfer meant she’d realize only a fraction of the reported account value.  For example, if she has held the two-tier annuity for ten years and then surrenders it for a lump-sum payment or transfer it to another investment/savings option, she’d receive approximately $203,095 before income taxes are paid.  This represents a penalty of $190,335 since the tenth anniversary account value (assume a 7% annual rate of return during the ten years) was reported as $393,430.  Obviously, a lump-sum withdrawal or transfer will be very painful and agonizing decision.  Let’s look at another option.

Let’s assume she decides to take a lump sum withdrawal and is in the 25% income tax bracket.  She will have after taxes about $202,320.  She will then use $100,000 to purchase the linked-benefit insurance policy described above.  Once the policy is issued, here is the protection she’ll enjoy: (a) $183,000 in life insurance which will be paid tax-free to her beneficiaries at her death; (b) $500,000 in LTC coverage paid at a rate of $5,952 monthly tax-free while receiving convalescent care in her home or elsewhere; (c) $18,300 in tax-free residual death benefit even if she uses all the $500,000 for LTC expenses; (d) the return of her $100,000 tax-free at any time with no-questions-asked if she needs the money for other uses or just changes her mind.  The other $102,320 can be redeployed in another annuity or alternate investment to grow and double as “rainy day money” to cover any unexpected expenses she might incur.  The income tax-free life, LTC and residual benefits are regardless of any other income she might have.  She has taken the lemon (two-tier annuity that has punishing withdrawal and transfer penalties) and made lemonade (linked-benefit policy and other investment of her choosing).

Beginning in 2010 an annuity can be transferred to a Long term care policy without being subject to income taxes.  The linked-benefit insurance policy presented above will qualify for this tax-free transfer.  The full-benefits of the linked-benefits policy, except the no-questions-asked return of the initial premium, is also available if the payments are made in installments over a period of years; thus, the two-tier owner can annuitize the full account value and use some of all of the annuity payments to pay premiums for the linked-benefit insurance coverage.

Of course, you can do this with any annuity or other investment you might own.  I’ve chosen the toxic two-tier because it is by far the most egregious when it comes to penalties for lump-sum withdrawal or transfer to another investment.  Also, many billions of dollars of two-tier annuities have been purchased – and mis-sold by financial service professionals – over the past ten years.  Unfortunately, many two-tier annuity holders do not realize the “gotcha” lump-sum withdrawal/transfer penalty until they actually want to sue their money.  So if you have the roach motel two-tier annuity (easy to get into but hard to get out of), you now have a good option to exit without leaving your skin behind.

Shelby J. Smith, Ph.D.
December 4, 2008