Editor's Note: The following article is a preview of a presentation to be given at the 46th Annual Heckerling Institute On Estate Planning conference, which will be held January 9-13 in Orlando, Fla.
Commercial annuities have long been dismissed by some estate planners as being more beneficial to the insurance agent selling them than for the purchaser or beneficiary.
However, in these difficult economic times, when it takes sophistication to make good investment decisions and when many estate owners do not have access to that type of professional advice, an annuity can achieve certain goals, even in the largest estates. There are three common scenarios that can arise in an estate plan in which an annuity can prove useful:
1. Providing for a longtime household employee.
2. Making a gift or bequest to an individual privately, when there are concerns about his or her ability to handle funds.
3. Managing the investment of a trust where the surviving spouse is not the parent of the remainder beneficiaries of the trust.
In these scenarios, an immediate annuity-an annuity contract where payments must begin within one year-may be appropriate. A deferred annuity, where funds accumulate until the contract is converted to an income stream, can be a useful tool in some estate planning situations, but not in situations that require payments to begin shortly after the annuity purchase.
Obviously, an annuity is not the sole solution to these situations; often, a trust could achieve the same goals with greater flexibility. However, trusts are expensive. Moreover, the selection of a trustee can be difficult and flexibility may not be a consideration. When this is the case, a commercial immediate annuity should be considered. If annuity payments are needed for the recipient's lifetime, a life annuity is required. If the goal is merely to provide a set number of payments, a period certain annuity is called for. In either case, consideration should be given to whether the annuity payments ought to be fixed, increase each year or vary with the performance of investments. In the first two cases, a fixed immediate annuity will work. (Many, but not all, immediate annuities offer a cost of living adjustment, in which payments increase each year by a specified percentage). In the third case, a variable immediate annuity is required in which annual payments may increase or decrease, depending upon how the variable investment accounts chosen for the annuity perform.
In any event, an immediate annuity will provide the certainty of an income for a period of years or for the lifetime of the "annuitant."
The first scenario is one that often arises in the estate plans of very wealthy individuals who employ longtime household help and want to provide for them at their deaths. Typically, the bequest is in the range of $50,000 to $250,000 and is intended to benefit employees who are accustomed to receiving a regular paycheck, with little or no experience dealing with large sums of money. Often, the estate owner is concerned about how well the recipient will manage a lump sum bequest, especially if it is intended to replace, if only in part, the salary he or she enjoyed while employed.
There is also the question of what size bequest will be "correct," since no one knows how old the employee will be at the estate owner's death or for how long the employee will need financial support. While these uncertainties would suggest a trust solution (since a trust could direct any amounts remaining at the death of the former employee to whatever remainder beneficiaries the estate owner wishes to benefit), it would be difficult to find someone willing to act as trustee for a trust of only $50,000 to $250,000. Even if a qualified trustee were found, the trustee fees would quickly deplete a trust of this size, even with modest distributions.
If, however, the estate owner were to direct that, at his or her death, an immediate annuity for life, of a specified annual amount, be purchased for the employee, the purchase price of that annuity-of either a fixed or annually increasing amount-will decrease over time as the employee grows older. (The cost of a life annuity decreases with the age of the annuitant at time of issue. While annuity rates may decrease as average life expectancies increase, the increase in age of an individual annuitant will almost certainly more than offset that trend). By contrast, a bequest to a trust to provide that employee with a specified lifetime income might well result in "overfunding" because, with each year the estate owner lives, the remaining life expectancy of the employee decreases.
With this strategy, the employee is guaranteed, at the estate owner's death, an income that he or she cannot outlive, no matter what. Moreover, neither a trust document nor trustees fees will be required.
The second scenario is also common with large estates. Here, the desire to ensure that the bequest is not squandered is paired with a desire to make the bequest private. If the annuity is purchased during the estate owner's lifetime, the transaction is not part of the written estate plan found in the will or revocable trust. But, if the annuity is owned at death by the estate owner, can be included in his or her estate and shown as an asset on the estate tax return. If the estate owner wishes to provide a legacy that will not commence until his or her death, a deferred annuity would be appropriate (as an immediate annuity must commence payments within one year of purchase). If the estate owner is willing to give the recipient access to the gift either in a lump sum or as a stream of income, the annuity payout options in a deferred annuity provide those choices. If there is concern that the recipient may squander the inheritance, a "restrictive beneficiary designation" can dictate that the accumulated value of the annuity must be taken by the beneficiary as an annuity, perhaps over his or her lifetime.
A trust will provide the same benefits and more security, as long as the trustee is given the power to cease distributions out of concern about what the beneficiary is doing with the money. However, the simplicity of an annuity is something that many clients respond to, even if it is not the perfect solution. Where the client has already established a trust for the benefit of a particular beneficiary, he or she may wish to purchase an annuity for that beneficiary as a supplement to the trust to ensure that he or she will always have income, even if the trustee makes no distributions from the trust.
In the third scenario, the client has established a trust for a beneficiary, but rather than purchasing an annuity outside of the trust, he or she directs that the trust itself purchase an annuity for the beneficiary. When a trust is created at the death of an individual for the benefit of his or her spouse and children, if the children are not also the surviving spouse's children, tension can develop over the trust's investments. The surviving spouse may be concerned about replacing the deceased spouse's income. Given the state of the economy and the low current interest rates, however, it may not be possible to replace the lost income from trust assets, so principal advancements will have to be made. The income-tax disadvantage applying to annuities owned by "non-natural persons" does not apply to immediate annuities and would be irrelevant, as immediate annuities do not accumulate "gain."
If the trust needs to produce as much income as possible, however, it may not benefit the children. That's because an investment strategy focused on income typically sacrifices asset growth. This may trigger a strained or even adversarial relationship between the surviving spouse and the stepchildren. The children, for example, may question the surviving spouse's standard of living and need for such income-something that was never done while the deceased spouse was alive.
It is possible to separate the two goals-growth for the children, or remainder beneficiaries, and income for the surviving spouse-with the use of an annuity. If the trustee were to sit down with the family to reach a mutual agreement that the trust principal would be divided into two parts, one part to be used to purchase an annuity to provide the spouse with the desired income, and the second part to be invested in growth investments for the benefit of the children, this may eliminate the tension between the family members. This idea may not always work, such as when the surviving spouse is very young or where his or her income needs are so great that the purchase price of an annuity sufficient to provide that income would consume too much of the trust corpus. If that is the case, an annuity could provide a portion of the spouse's needed income and the rest of the income needs could be met by other trust investments. This would relieve at least part of the pressure on trust investments to produce increased income.
In some estate planning situations, the use of an annuity is problematic, such as when the trust must qualify for the marital deduction from estate or gift taxes. One requirement of such a trust is that the spouse must receive all the income from the trust or a stated percentage of the trust fund in certain states where marital unitrusts are permitted. Paying the spouse the annuity payments will not satisfy that requirement. Moreover, in marital or non-marital trusts entitling the surviving spouse only to income, but not distributions of principal, the annuity would probably be considered an impermissible distribution of principal. If the family wants to proceed with this plan, the trust terms would have to be reformed, which is possible in most states either informally or through a court proceeding.
The regulation of annuities and those who sell them is full of uncertainties today, and is undergoing a transformation with the enactment of the Dodd-Frank financial reform act and other recent developments.
The purchaser of a fixed annuity receives at least a guaranteed minimum rate of return over the contract term. The insurance company assumes the risk of paying out this minimum return, even in a down market. As a result, fixed annuities are generally characterized as insurance products, regulated by state insurance commissioners, and exempt from the Securities Act of 1933 pursuant to Section 3(a)(8). The National Association of Insurance Commissioners (NAIC) has issued Suitability in Annuity Transactions Model Regulation 275 (SATMR), which sets forth suitability standards for annuity products. Many states have adopted SATMR. Moreover, state securities laws may apply to fixed annuities.
A variable annuity differs from a traditional fixed annuity because the risk of total loss shifts to the purchaser, who has no floor that acts as a "stop loss" on the rate of return if the underlying portfolio performs poorly. With no element of fixed return, the insurance company assumes no true investment risk. Over 50 years ago, the U.S. Supreme Court determined that variable annuities were securities and were subject to regulation under the federal securities laws. Because variable annuities are securities, those selling them are required to obtain securities licenses and adhere to FINRA requirements. In some states, a variable annuity is not considered a security.
In response to consumer demand to combine the benefits of increased stock market returns with protective floors against market downturns, the equity-indexed annuity was created. Initially, the SEC tried to treat equity-indexed annuities as securities, but after judicial repudiation the SEC withdrew its regulation. An amendment in the Dodd-Frank Act provides an expansive safe harbor that exempts from federal securities regulation not only equity-indexed annuities but also fixed annuities that meet its conditions, preserving state regulation of these products. Variable products cannot rely on this safe harbor exemption.
For now, an insurance agent seeking to comply with SATMR must gather certain information and must possess reasonable grounds to believe that an equity-indexed annuity transaction being recommended is "suitable" for the consumer. Broker-dealers may elect to subject equity-indexed annuity sales to the FINRA suitability rules. Sales made in compliance with FINRA rules are deemed to qualify as complying with the NAIC's SATMR rules. Dodd-Frank also contemplates the SEC applying a fiduciary standard to broker-dealers, as well as instituting federal oversight of life insurance, but the impact on insurance companies and those who sell their products remains uncertain.
Mary Ann Mancini, Esq., heads the worldwide private client practice of Bryan Cave LLP.
John L. Olsen, CLU, ChFC, AEP is co-author of The Annuity Advisor, Index Annuities: A Suitable Approach and numerous articles on annuities.
Melvin A. Warshaw, JD, LLM, is general counsel at Financial Architects Partners and an author and speaker.