AN ANNUITY: WHAT NO WELL-HEELED CLIENT CAN DO WITHOUT

Tell affluent client prospects about why an annuity is critical to a balanced portfolio for achieving financial planning objectives and their eyes are likely to roll. How, they might ask, can an annuity–a product commonly used by mid-income households to cover basic expenses in retirement–compare with the many alternative investments available to the wealthy? The better educated among the affluent already know the answer. Increasingly, sources tell National Underwriter, high net worth clients are turning to variable, fixed and fixed indexed annuities because of their unique ability to provide a guaranteed income stream, as well as tax efficiency during both the accumulation and income distribution planning phases. The spread of this enlightened, well-heeled population is evident in the numbers. According to survey by Cogent Research, Boston, Mass., 34% of 4,000 affluent investors (defined as individuals with $100,000-plus in investable assets) have purchased annuities, including both variable and fixed products. That is up from the 30% Cogent recorded in 2006. Why the change? A key reason is the more conservative orientation of investors in the wake of the severe recession beginning in 2007 and a concurrent plunge in equity values that did great damage to clients’ portfolios and retirement plans. “There has been a big shift among investors moving from high to low-risk portfolios,” says Meredith Lloyd-Rice, senior project director at Cogent. “The most dramatic change was in October of 2008, when the proportion of assets that was low-risk went from 26% to 32%. In 2009, the percentage rose again to 34%.

It seems that clients remain very wary of the market.” High net worth clients, observers say, are also turning in growing numbers to annuities and tax-favored vehicles to minimize the impact of pending tax hikes. The healthcare bill that President Obama signed into law earlier this year contains about $438 billion in revenue increases over the next decade. Among them: a 0.9% Medicare payroll tax increase starting in 2013 for individuals and couples earning more than $200,000 and $250,000, respectively; a new 3.8% tax on income from investments including capital gains, bringing the top tax rate on capital gains to 23.8% in 2013. The tax on dividends can also rise to 43.4% when the Medicare tax takes effect. Also on the horizon is (absent Congressional action) the expiration at the end of 2010 of President George W. Bush’s tax cuts in 2001 and 2003. The top tax rate for married couples earning more than $373,650 is due rise to 39.6% from 35%. The 33%, 28% and 25% tax brackets for household incomes ranging from $68,000 to $373,650 will also be ratcheted up to 36%, 31% and 28%, respectively.

What’s more, President Obama proposes to cap itemized deductions at a 28% rate for taxpayers in the top two tax brackets; restore a 20% rate (now 15%) on capital gains and dividends for taxpayers in the two brackets; and adjust the alternative minimum tax (AMT) to account for inflation. “As income taxes go up and personal exemptions are phased out, the ability to defer income taxes becomes more valuable,” says Moshe Milevsky, a professor of finance at York University, Toronto, Ont., and executive director of the Toronto-based Individual Finance and Insurance Decisions (IFID) IFID Centre. “And with annuities, you don’t have to tax investment gains until you start taking payments.” Like cash value life insurance, annuities enjoy tax-favored treatment under the IRS code in that funds grow tax-deferred until withdrawn. That feature is especially prized by holders of variable products, the subaccounts of which may be invested in a range of equity-based investments, including mutual funds and ETFs. The other key features of the variable products–the guaranteed minimum income, accumulation, and withdrawal benefit riders–continue to fuel strong demand for VAs. But Milevsky asserts, the riders becomes less important, and tax-deferral progressively more important, in proportion to one’s wealth and income. “For the high net worth crowd, a scaled down, no bells-and-whistles version of the product will be most appealing to them,” he says. “Every basis point they pay in fees for a product offering guarantees costs them. They want the scaled down version because they just want tax-sheltered growth.” To be sure, says Milevsky, a client’s income is not the only factor to weigh when judging the merits of the annuity as a pure tax play versus a source of guaranteed income in retirement. Also to consider is the client’s age: The further one is from retirement, the more appealing will be the tax-sheltering sales pitch. In contrast, lower income-earners who are at or near retirement and who will depend on an annuity (in addition to Social Security and an IRA or pension) to fund basic living expenses will give greater priority to income guarantees.

Other experts don’t see guarantees versus tax-sheltering as an either/or proposition. Indeed, some advisors are doing a lucrative business marketing guarantees on variable and fixed indexed products. Example: Herbert Daroff, a partner at Baystate Financial Planning, Boston, Mass. He says the appeal of the riders has less to do with tax brackets and market demographics than with the degree to which clients may be risk-averse. The VA guarantees, he notes, give the affluent individual “permission” to stay invested in the equities markets; and, indeed, to invest more aggressively than they may otherwise be inclined to do. For Daroff and his clients, the most valued of the riders is the guaranteed minimum income benefit. Purchased by those who plan to annuitize, the GMIB rider assures VA holders that they will receive income regardless of market conditions, the minimum payment predetermined by the future value of the initial investment. Daroff says he most often recommends the GMIB option for individuals invested in small cap and international funds–segments of a mutual fund portfolio that he views as especially volatile. In the event such funds should forces a VA’s market value to fall to zero, the insurer will still provide a minimum interest rate (usually 5% or 6%) for the duration of a specified period (typically 10 years), the interest constituting a “base benefit” that is used to calculate the guaranteed income stream. “All the magic of the VA is in the rider,” says Daroff. “With the GMIB option, if the market goes up, you win: the VA’s value resets to a new floor or benefit base. If it’s tales, you don’t lose–you still get 5% to 6%. For risk-averse investors, however affluent, the VA is a very powerful tool.” Some VAs, Daroff adds, also allow retirees to tie the guaranteed rate to IRS-mandated required minimum distributions, which may stipulate higher annual income payments (e.g., 8% or greater). This RMD-matching feature, he notes, is especially valued in cases involving “stretch IRAs:” vehicles for extending the duration of tax-deferred benefits of an IRA to a succession of beneficiaries beyond the originally designated beneficiary. Because annuities are used both for cash accumulation (during one’s working years) and income (in retirement) sources caution that savings achieved through tax-deferral may not be fully realized if clients fail to consider how the products are taxed when they begin taking payments. They therefore must factor in the product’s exclusion ratio: the proportion of taxable to nontaxable proceeds during distribution.

Curtis Cloke, founder and CEO of Thrive Income Distribution System and an advisor at Two Rivers Financial Group, Burlington, Iowa, says that most income annuities offer last-in, first-out (LIFO) tax-treatment. Translation: all of an annuity’s taxable gains are paid out first, followed by the non-taxable principal or basis. This method of payment, says Cloke, could result in individuals and couples earning, respectively, more than $200,000 and $250,000 in modified adjusted gross income, subjecting them to the new 3.8% Medicare surcharge on passive income beginning in 2013. The key to circumventing the tax, he suggests, is to leverage period certain immediate or deferred income annuities that pay out the gain and income principal on a pro rata basis (i.e., a portion of the taxable gain is distributed with non-taxable basis with each payment.) “Because you can do this, you can create extremely high cash flows while keeping the taxable portion at a certain level,” says Cloke. “Clients who need income above the $200,000 for single filers or $250,000 for joint filers can actually control their modified AGI by adjusting the flow of taxable income.” “Taxes will be the most significant issue that high net worth clients will need to focus in coming years because of the tax increases planned from 2011 to 2013,” he adds. “So techniques that allow them to distribute income more tax efficiently will be of great interest. Income annuities that pay out using the pro rata formula I’ve described allow them to do just that.” Thomas Hamlin, a producer and branch manager at Raymond James Financial Services, agrees. “This strategy is totally underutilized by the high net worth,” says Hamlin. “That’s in large measure because the investment brokers who advise them believe that annuities are too expensive and have no place in the client’s portfolio. “But these products represent for the affluent an incredible vehicle for achieving both growth and income distribution objectives.”

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