If a number of selected industry seers are right, life annuities may become the planning tool of choice in a growing number of client situations. As the number of defined benefit plans shrinks and the uncertainty about future Social Security benefits lingers, advisors increasingly will consider other avenues to lifetime income for their clients.
Life annuities, defined as annuities in their distribution phase, in which payments are made for at least the annuitant's lifetime, can be part of a tax-advantaged retirement plan or an after-tax portfolio. In the former, life annuities are provided through employer-sponsored defined-benefit plans or as a distribution option in defined contribution plans. As part of an after-tax portfolio, life annuities can be either an immediate annuity, which begins payments immediately after purchase, or an annuitization of a deferred annuity.
The reasons for expected strong growth of new life annuities fall generally into four main categories:
Demographics. Approximately 70 million baby boomers will enter retirement in the next 30 years, an unprecedented number of nonsalaried people needing regular income. With earlier retirement ages and longer life expectancies, retirement assets may need to last as long as 30 to 40 years, far longer than what was required in earlier generations.
Decline in defined benefit plans. According to the U.S. Labor Department, the number of defined benefit plans dropped from 121,655 in 1977 to 59,499 in 1997. During that same period, the number of defined contribution plans jumped from 280,972 to 660,542, thus shifting the risk of providing sufficient retirement income from the employer to the employee.
Growing appreciation for lifetime income. Thanks to sophisticated tools such as Monte Carlo simulations, advisors and clients are becoming more knowledgeable about sustainable (and unsustainable) levels of portfolio withdrawals. Now that baby boomers have tasted a market decline, they may be more realistic about expected returns and more willing to consider more predictable, albeit less exciting, returns for part of their assets.
Product Enhancements. Tra-ditionally, one of the biggest fears of annuitizing was the loss of access to liquidity. Once the owner annuitized, his payment schedule was locked in, and he could not take additional withdrawals. In a fixed annity, theowner also lost the ability to change investment options. However, some of the newer annuitization options allow for subsequent withdrawals, albeit at a cost, and TIAA-CREF's
new immediate fixed annuity even allows gradual shifts out of the fixed investment into variable options.
The climb up the ladder of respectability won't happen overnight. The after-tax annuity industry has been severely tainted by a history of big expense ratios and churning of contracts. According to Michael Lane, author of Guaranteed Income for Life and TIAA-CREF's new director of advisory services, many insurance companies in the past actually trained new hires to replace clients' contracts every few years, thus generating hefty commissions for brokers.
Lane also faults certain brokers and agents who never recommend that clients annuitize their contracts, since they no longer can earn new commissions of 5% to 7% on those funds. "When brokers recommend annuitization," he says, "they lose a source of future commissions. In addition, annuity trailers, which typically run about a quarter of one percent annually on deferred annuities, generally cease upon annuitization." Lane thinks the current low rate of annuitization of deferred annuity contracts, estimated at only about 4%, is significantly related to the commission issue. By not tapping into the annuitization option, he says, policy owners are losing out on perhaps the strongest feature of annuities: the guarantee of lifetime income.
Certain experts disagree with Lane, contending that the annuitization rate is low because the vast majority of annuity holders haven't retired yet.
Paul Yakoboski, director of policy research at the American Council of Life Insurers (ACLI), says he feels certain the percentage of annuity reserves that are annuitized will grow, coming from annuitization of deferred contracts and purchases of immediate annuities. "It may not happen immediately," he said, "but in the long run, absolutely. It will be driven by demographic trends and the flow of money into immediate annuities from employment-based retirement plans." Increasingly, he expects employers to offer annuitization options with their defined-contribution plans.
Market Fueled Annuities' Growth
Despite the questionable image of some annuity brokers, annuities have racked up significant gains in assets and premiums for insurance companies over the past decade. According to the ACLI, annuity reserves grew at an annualized rate of 11.1% from 1989 to 1999 to reach a total of $1.8 trillion, which was divided almost equally between group and individual annuities. Immediate annuities represent about 30% of group annuity reserves and about 11% of individual annuity reserves; deferred annuities make up the rest.
Variable annuities, which are invested predominantly in equities, have claimed the lion's share of the growth, thanks to the appreciation of equity values in the 1990s and to far more purchases of variable annuities than of fixed annuities. Variable annuity premiums grew at a staggering 40% annualized rate from 1989 to 1999, compared with the 1.7% growth rate of fixed annuity premiums. Total annuity premiums reached $270 billion in 1999, with variable premiums contributing slightly more than half. (ACLI Life Insurers' Fact Book, 2000).
The more recent trends are far different, however. Preliminary estimates from industry-tracking LIMRA International show total industry premiums dropped 10% in the first quarter of 2001, compared with the first quarter of 2000. Affected by market weakness and investor wariness, variable annuity sales fell 21%, breaking a streak of 22 consecutive quarters of year-over-year gains. Fixed annuity sales, on the other hand, jumped 24% to reach their highest levels since early 1995.
Client Considerations
A big challenge for financial advisors, after first advising clients to maximize pretax savings opportunities, has always been that of determining whether certain clients were better off saving for retirement inside a deferred annuity or simply in an after-tax brokerage account with mutual funds, stocks and bonds. With deferred annuities, growth accumulates on a tax-deferred basis; the longer the accumulation period, the greater the tax deferral. Once the owner starts taking distributions, he incurs ordinary income taxes on the growth portion of the benefit payments. For years, advisors have tried to determine how many years of tax deferral are required to make annuities preferable to investments in a taxable account, where realized gains are taxed at the lower capital gains rate. With variable annuity expense ratios averaging more than 2%, many advisors have maintained that deferred annuities are never appropriate.
Immediate annuities are gaining favor, though. Despite the overall drop in first-quarter annuity sales, LIMRA reports that immediate annuity sales registered gains of nearly 50%, granted from a much smaller base than that of deferred annuities. Time will tell whether immediate annuities have just entered a sustained period of strong growth.
The insurance benefits of annuitizing a deferred annuity and purchasing an immediate annuity are essentially the same, assuming similar payout options. Basic benefit-payment options such as single or joint-life payouts and guaranteed periods are available with both. Tax-related considerations can differ, however, depending upon whether sizable capital gains taxes are incurred to raise funds for purchasing an immediate annuity, for example, and whether large gains have accumulated in deferred annuities. As noted, the portion of nonqualified annuity payments that represents growth is taxable, whereas the return of principal portion-called the exclusion ratio-is not. If an annuity costs $100,000 and is expected to pay out $160,000 over the life of the contract, the exclusion ratio is 62.5%. Once the entire $100,000 premium has been returned to the client, further payouts are 100% taxable.
Since there's generally a loss of liquidity during annuitization, it's important to keep sufficient reserves outside of a life annuity for emergencies or other needs. A partial distribution can be taken from a deferred annuity before annuitizing the remainder, and some companies allow partial 1035 exchanges so that one contract is annuitized and the other remains deferred. It's also critical to be certain of the insurance company's financial strength before annuitizing, particularly when using a fixed annuity that's invested in the company's general account. Comparison shopping may reveal other policies with lower expense ratios or more attractive investment options or payout terms. You can easily do a tax-free 1035 exchange into another policy before annuitizing, but not afterward.
What types of clients are the best candidates for annuitization? Yakoboski thinks it's the large middle-class sector of retirees that can benefit the most. "For people who are very well off, annuitization probably isn't called for as much, quite frankly," he said. And for those struggling to make ends meet, Social Security will continue to be their primary source of retirement income. "But there's a vast number of people who fall in the middle ground, for whom it makes a lot of sense to annuitize a healthy chunk of their assets and have a stream of income that they can't outlive," he said.
Avoiding Financial Ruin
In retirement planning jargon, that possibility of outliving one's assets is called the "probability of ruin" or "risk of failure." Advisors' desire to get a better handle on the ability of retirement assets to last throughout their clients' lives has fueled considerable debate and a proliferation of software with Monte Carlo simulations designed to illustrate sustainable withdrawal rates over varying retirement periods and asset allocations. Most experts, such as Bill Bengen and Gordon Pye, agree that 4% is about the highest withdrawal rate that can be sustained over a long retirement period with a moderate-growth portfolio. Severe market declines early in one's retirement years are particularly damaging to the withdrawal rate that a portfolio can maintain.
In a recent study, TIAA-CREF Institute's Research Director Mark Warshawsky analyzed the reduction in "risk of failure" that can occur if a portion of one's retirement portfolio is annuitized. Using a 4.5% withdrawal rate and assuming a 7% rate of return on the pooled annuity assets, he found that the chances of failure drop from about 13% in a growth portfolio over a 30-year period with no annuitization to about 8% if 25% of the portfolio is annuitized, and to only 3.3% if half the portfolio is annuitized.
That greater security comes with a tradeoff. "The simple fact that the annuity dampens future uncertainty virtually guarantees that there will be less opportunity for retirees' portfolios to grow as large as in the nonannuitized case," Warshawsky says. The presence of the pooling arrangement effectively shortens the tails of the distribution of future portfolio wealth-making it less likely that the investor will go broke, but also reducing the size of the accumulation that will be passed to heirs."
This brings us to the feared prospect of dying soon after annuitizing and simply losing the bulk of one's investment. That fear, often cited as a major reason that contracts aren't annuitized, can be put to rest through commonly available options that offer a guaranteed payout period of five to 20 years. This feature allows the payments to continue to an owner's beneficiary if the owner dies before the end of the guaranteed period. The longer the guaranteed period, of course, the lower the guaranteed monthly payment.
Hurdles To Acceptance
Despite the perceived benefits of annuitization, there are some hurdles to overcome before the advisory community will embrace the concept wholeheartedly. One is a general lack of understanding of the risks and rewards of annuitization. Even some of the country's leading advisors say they need to know more about the inner workings of annuitization before they'll start recommending immediate annuities to their clients. "Right now, we're still trying to understand the mathematics of annuitizing," says advisor Harold Evensky of Coral Gables, Fla. "We need to know a lot more about the tax implications of annuitizing and how much of the mortality benefits go to the company and how much to the annuity owner."
Evensky's interest is definitely piqued by the prospect of immediate annuities being able to solve certain clients' legitimate fears of outliving their resources. In June, a couple of AEGON Financial executives met with Evensky and his staff to discuss some intricacies of annuitization. "My gut feeling is that immediate annuitization is going to be one of the most important vehicles that we're going to be using for retirement planning," Evensky says. That's a pretty striking comment from someone who's long been a critic of deferred annuities, except in rare cases.
Another advisor, Joel P. Bruckenstein of Mirimar, Fla., says he would like more transparency within the fixed annuity. "You don't know what they are earning on the assets, so if they promise to pay you X amount, how do you know if they will be able to keep their promise?" he asks. "If we are going to buy these policies to insure for a 30 to 40-year time horizon, and there is no going back once you annuitize, using the financial ratings may not be enough. I need to understand the portfolio that backs the annuity and what the mortality figures are."
The choice between a fixed annuitization and a variable annuitization requires serious analysis. While variable annuitizations have the drawback of reduced benefit payments in down markets, fixed annuitizations can entail significant interest-rate and purchasing-power risk. Many advisors simply are not comfortable locking in current rates that are much closer to historical lows than historical highs.
"The problem with a fixed annuity is that you have opportunity costs. What if interest rates go to 10%?" asks advisor Janet Briaud, of Bryan, Texas. If you think inflation and interest rates are going to rise, she said, fixed annuities really don't make any sense, and you'd be better off in short-term bonds. "On the other hand, if you think interest rates may continue downward and you've got longevity in your family, fixed annuities look more appealing."
Getting Paid For Fewer Assets?
In addition to the complex cost/benefit analysis of annuitizations and the challenge of comparing the enormous array of available policies, advisors also have to wrestle with the issue of compensation. Just as brokers and commission-based advisors have been faulted for not annuitizing contracts due to the loss of future commissions, fee-only advisors can be criticized for similar reservations. Because most fee-only advisors charge clients on a percentage of assets under management, annuitization results in lower fees as assets are removed from the base of managed assets.
"It's been real easy for us fee-only advisors to point the finger at the commission-based people," noted Evensky. "But the shoe is on the other foot this time." Evensky's solution is to move toward a customized comprehensive fee that covers all the services that his firm provides to a client. Generally, there's a correlation between the client's overall wealth and the annual fee. As for commission-based advisors, immediate annuities may gain appeal as more policies contain trailers.
In sum, life annuities appear to offer some attributes that could be beneficial to certain clients, particularly those who need to lock in some predictable income and avoid depleting their assets during their lifetimes. As one observer noted, annuitization gives the advisor one more tool in his toolbox, albeit a more complicated one than most others. But it is hoped that the more complicated the issues, the more helpful the financial advisor.
Mimi Lord is senior editor of MorningstarAdvisor. TIAA-CREF is a participant in the Due Diligence Center of www.morningstaradvisor.com. Mimi can be reached at [email protected].