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Journal of Financial Planning - February 1998 The question of whether lower capital gains rates make variable annuities less attractive is not the issue. Planners need to take a far broader view as to whether VAs are right for a particular client. Taking the Macro View on Annuities by Peter Katt, CFP, LIC Since the last tax act that lowered the tax burden on capital gains, I have been asked numerous times whether variable annuities have lost some of their appeal compared with purchasing equities sans the variable annuity wrapper. The answer to this question, according to my friend Glenn Daily, a New York City-based insurance consultant, is yes, slightly. But the interest in this narrowly defined question raises a far more important issue, which is that too many financial planning decisions are made while studying micro rather than macro questions which, if properly explored, would clearly expose the most logical course. Deferral - Then What? Many deferred annuity sellers focus their attention on the tax deferral characteristic (which gives rise to the frequency of the question I have been asked regarding variable annuities and the recent tax act). They start comparing policy features such as current yields, investment expenses and surrender charges without stepping back to view the totality of their client's circumstances, which also would include considering possible annuity pay-out scenarios. It is my contention that if the complete client picture were given sufficient attention, many fewer deferred annuities would be sold. Three case studies will make my point. Professor Jennifer Brown Jennifer is a 50-year-old widow with no one financially dependent on her. She has earned royalties on several books that have a present value of some $250,000 that she doesn't need for her living needs or as an emergency fund while she is employed at the university. She is an avid golfer and would enjoy taking early retirement and moving to a plush golf course community in Arizona in 12 years. However, she is concerned that by taking early retirement, her university pension and Social Security will not be enough to provide her with the income she will need to live in such a community and play golf every day. If Jennifer purchases a $250,000 deferred fixed annuity now and exchanges it for an immediate fixed annuity in 12 years, the annuity may produce an after-tax income of $3,000 a month for life, assuming a six percent interest factor. This is an ideal asset purchase for Jennifer because she doesn't need the $250,000 until retirement, her employment earnings are relatively high, placing her in a high marginal tax bracket, and she has no one financially dependent upon her, so having an asset that expires upon her death is not a problem. Bill and Helen Moore Bill is 36 and has been a pharmaceutical sales rep for 8 years. Helen is 34 and a fifth-grade teacher. They have two children, ages eight and six. Bill is very good at his job, but his income prospects and total job fulfillment are limited because he is unwilling to accept promotions that would cause the family to move every few years. Due to the death of Bill's mother, they have recently inherited $300,000. Bill and Helen have sufficient term life insurance and their family finances are in good order so the $300,000 isn't currently needed. Bill and Helen retain Fred, a financial planner, to advise them regarding this inheritance. After obtaining financial and family information, Fred recommends-and they purchase-a deferred annuity. Two years after purchasing the deferred annuity, with his company pension vested, Bill decides to set up his own rep firm for manufacturers of medical devices. He decides to withdraw $100,000 from this annuity for start-up costs. The withdrawals, he discovers, are subject to taxes on the earnings, plus a penalty tax and a partial surrender charge of five percent. A year later, encouraged by a wonderful start to his new business, Bill decides to expand, hiring two associate reps. When Bill surrenders the deferred annuity to fund this expansion, he discovers he has a bit more tax exposure and a surrender penalty of four percent on the balance. Had Fred's financial planning methods been able to extract from Bill the fact he was not happy with his job and would be vested in his pension plan in two years, or had Fred been explicit about the consequences of premature withdrawals and surrenders, Fred and Bill probably would have taken notice of the possible future scenario that occurred. Investing the $300,000 with the view that it could possibly be temporary would have served Bill and Helen's best interests. Jeff and Sharon Tyler Jeff is a 38-year-old heart surgeon. Sharon, 37, is a stay-at-home mom, trained as a nurse. They have four children, ages two to eight. Due to Jeff's income, the Tylers are able to invest, for medium- and long-term purposes, approximately $45,000 each year above the tax-deductible pension contributions being made via his medical corporation. Jeff's and Sharon's most visible financial goals are tax-deferred investing, possibly to be used for education costs and to augment their retirement, and to significantly increase Jeff's life insurance coverage. Their financial planner, Alan, is proud to be known as a termite, or someone who only recommends term insurance. So Alan recommends $3 million of 20-year level term insurance, at a cost of $5,000 a year, and the purchase of deferred annuities, expected to be purchased at the rate of some $40,000 each year. Due to some deterioration in Jeff's earning power and increases in college costs, Jeff has to cash in some of his annuities during the peak college-cost years. Each such surrender causes current taxation on the gain, plus some penalty taxes for surrenders done before Jeff reaches age 59 1/2. At retirement, due to the large amount accumulated in Jeff's pension plan, exchanging the remaining deferred annuities for immediate annuities isn't needed. Jeff and Sharon decide to use the deferred annuities as wealth transfer estate planning assets by transferring them outside of the estate. Unfortunately, even though the annuity proceeds will not be subject to estate taxes (if Jeff lives three years after the transfers), all of the gain will be subject to income taxes at Jeff's death. Had Alan given sufficient attention to possible pay-out scenarios, he might have thought to offer as an alternative a superfund-a universal or variable universal life (UL) policy for half of Jeff's life insurance needs ($1.5 million), with term insurance for the other half. Superfunded life insurance provides needed death benefits and a significant tax-deferred investment element that has very different pay-out characteristics compared with deferred annuities. Using low-load UL and assuming a crediting rate of 6.4 percent, by the time peak college costs arrive (age 52), Jeff's UL policy would have projected cash values of some $940,000, with a cost basis of $595,000 (premiums paid at the rate of $42,500 a year). Based on this scenario, Jeff could stop making premium payments and withdraw $20,000 from the UL policy for ten years. Unlike the surrender of deferred annuities, which causes taxes and penalties on the gain, withdrawals from such a UL policy don't cause any taxation because withdrawals are tax-free up to cost basis. Then, if Jeff resumed making the premium payments for the several years before retirement, the policy would have a projected cash value at retirement of $1.9 million, with a remaining cost basis of $522,500. Jeff and Sharon could withdraw this $522,500 tax-free, and then transfer the policy out of their estate. If Jeff lived to age 85, the projected death benefits would grow to $5.2 million, which are entirely income-tax-free. Compared with buying term insurance and investing in deferred annuities, purchasing a superfunded UL and 20-year level term in equal amounts would be a much better alternative. Conclusion Some financial planners are quick to recommend various
flawed financial assets because they improperly focus their attention
on micro issues, while failing to observe and imagine the broader implications
of their clients' possible or likely future needs. The reduced tax burdens
associated with capital gains and its apparent significance for variable
annuities is an example, in my opinion, of this kind of myopic financial
planning thinking. As demonstrated in the theoretical case studies presented,
a decision to purchase deferred annuities should depend on factors far
more substantial than whether the tax code has been tweaked yet again. Reprinted with permission by the Financial Planning Association, Journal of Financial Planning, February 1998.
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