Investors & Objectives

Other investment factors


During their lifetimes, most individuals will have investments objectives of accumulation, conservation, distribution and transfers.  What makes each client unique, however, is the particular set of circumstances each individual faces.  Advisors must apply their creative talents to adapt general investment concepts to each client's situation.  The decision whether the purchase of annuity is suitable must be based on each client's unique set of circumstances.  And if an annuity is purchased, the advisor should maintain contact with the client to monitor whether the annuity remains a suitable investment as the client's objectives and circumstances change. 





Liquidity, the ability to easily turn an investment to cash without incurring large expense, is a major factor in most investment decisions.  Annuities should only be purchased with "long-term money", i.e., funds that the investor can afford to invest over a long time horizon.  Before making a decision to purchase an annuity, the investor should ask: "Is this money that I can afford to tie up for an extended period?" and "Do I have adequate reserves of cash or short-term investments to meet daily living expenses and unforeseen emergencies?"  If the answer to either of those questions is "No", then an annuity is not a suitable investment. 


Annuities can be readily converted to cash, either through withdrawals in the accumulation period or by converting the contract into a stream of income payments.  There are, however, a couple of key points to keep in mind.  Most contracts impose surrender charges for withdrawals in the early years of the contract.  These fees are usually on a sliding scale beginning with relatively large surrender charges in the earliest years, tapering off over the first five to seven years, and no surrender charges after that point.  Surrender charges are typically waived for beneficiaries in the event the contractholder dies.  For annuity issuers, marketing and underwriting costs represent a large upfront expense that must be recovered in order for the company to earn a profit.  The company recoups those costs over the life of the contract.  For issuers, the concept of "persistency" is critical to its profitable operations.  Persistency is the average length of time a contract remains in force.  Contracts that are quickly surrendered represent a losing proposition.  Surrender charges are a way to recoup some of the upfront costs on contracts that are surrendered in the first few years.  They also remind clients that annuities should be a long-term investment. 


Another hurdle that makes annuities rather illiquid applies to deferred annuities only.  The IRS essentially views deferred annuities (those with an accumulation period) as a retirement savings vehicle.  As such, it grants special tax-deferred status to deferred annuities.  If the client withdraws funds from the annuity prior to age 59˝, the IRS will impose a 10% penalty on the withdrawal.  This is similar to the penalty for premature withdrawals from tax-qualified retirement plans and IRAs.  The penalty only applies to withdrawals during the accumulation period and not to contracts that are annuitized into a stream of income payments.  


Recent changes in Florida law have been predicated on misrepresentations of the liquid (or illiquid) nature of annuities.  The suitability disclosure requirements discussed in Chapter 6 are a direct result of those misrepresentations particularly to elderly clients. 



Tax status


One of the key selling features of annuities is their tax-deferred status.  Earnings in the contract grow tax-deferred, allowing the contractholder to "triple compound" his interest -- interest is earned on the initial investment to the contract, on past earnings in the contract and on monies that would have been used to pay taxes on those earnings.  By contrast, earnings from investment in a taxable investment, such as a mutual fund, are taxable in the year they are distributed to the investor.  If the investor chooses to reinvest, only the after-tax portion of the distribution is available for compounding.   Triple compounding allows for faster capital appreciation in tax-deferred contracts, and as you would expect, this is a strong incentive to invest in annuities.  There are, however, tax disadvantages to an annuity too.  Earnings will be taxed when the account's value is distributed to the contractholder -- either as a withdrawal or as a series of periodic payments.   All growth in an annuity contract's value regardless of its source -- is taxed as ordinary income, not capital gains.  By contrast, profits on investments in taxable securities like mutual funds, stock or bonds, will be subject to more favorable capital gains treatment when the security is sold. 


When comparing a tax-deferred annuity to other taxable alternatives, advisors should be careful to address both the tax advantages and disadvantages of the annuity.  Whether the annuity makes more sense from a tax perspective depends on the investor's current tax bracket, the investor's projected tax bracket when monies will be taken out, the difference between the ordinary tax rate and the capital gains rate, and the expected timeframe of the investment (the time earnings will grow tax-deferred).  Obviously future changes in the tax code may also affect whether the annuity turns out to be the better investment. 


In some cases, an investor will wish to purchase an annuity within a qualified retirement plan or Individual Retirement Account.  As discussed in Chapter 2, tax-deferred annuities are taxed similarly to these plans: tax-deferred growth, distributions taxed as ordinary income and a 10% penalty on withdrawal prior to age 59˝.  Some advisors find the idea of placing a tax-deferred annuity within a tax-deferred retirement account to be an unsuitable recommendation under any circumstance.  The premise of this argument is that the beneficial tax status of the annuity is "wasted" when it is placed in a tax-deferred retirement account. By that same logic, investors should never purchase stocks or mutual funds in their IRAs as the favorable capital gains treatment afforded these investments is "wasted", since the eventual distribution of the gain from the IRA will be taxed as ordinary income.   Few advisors would make that argument.  The tax status of the investment outside a qualified retirement plan should not be a reason to disqualify including that investment in the plan.  (The converse, however, may be true it often makes sense to place less tax-advantaged investments into a retirement account.)  There may be many reasons to not purchase a deferred annuity within a retirement account, but this "wasted" tax benefit argument is not one of them.   



Time horizon / Age


The earlier discussion about individual investment objective was based, in part, on the natural aging process.  As investors grow older, there is less time to recoup losses, which leads to a natural progression from asset accumulation to wealth conservation.  Advisors must pay careful attention to their client's investment time horizon.  Quite often that is based on age, but sometimes the time horizon is determined by other factors.  Parents saving for their children's college education may be concerned with distributions from their investments at a time in their lives when asset accumulation would seem to be an important goal.  Likewise for other needs saving for a down payment on a house or vacation property, the projected buy-out of a retiring partner's business interest, etc.  While age is certainly an important factor in many investment decisions, advisors should inquire as to the purpose of the investment prior to making a recommendation.


As we’ve mentioned earlier, there have been numerous complaints about sales of annuities to elderly clients.  Placing a client into an investment with substantial surrender charges that may remain in force for most of the client's remaining life expectancy is viewed very dimly by state insurance regulators.   As we'll see in Chapter 6, Florida imposes a suitability disclosure requirement when annuities are recommended to anyone age 65 of older and FINRA imposes disclosure requirements on the sale of variable annuity contracts to clients of any age. 



Risk aversion


Some clients are inveterate gamblers; others are Chicken Littles who see the sky falling with each downturn in the market.  Advisors should take the time to understand the client's tolerance to risk.  Long-term (and profitable) relationships are built on mutual understanding.  Advisors should determine whether their clients can sleep at night with the investment decisions they have made, and clients should be aware of the imprecise nature of investment analysis in a world of imperfect information.  


All investments carry a degree of risk; some more pronounced than others.  In some respects each investment's risk is unique to that investment.  There are, however, four general risks that investors should consider when making any investment:  interest rate risk, purchasing power risk, creditor risk, and market (or systemic) risk.


Interest rate risk is the risk that interest rates will rise in the future.  Rising interest rates make existing fixed income securities with their older, lower rates of interest less attractive.  If the older security needs to be liquidated prior to maturity, the investor will suffer a loss.  Even if the investor can hold until maturity, there is the opportunity cost of having locked into a lower rate than what could have been earned otherwise.  Fixed annuities, with their guaranteed rate of interest are subject to this opportunity cost.  Most issuers of fixed annuities will set a new rate for the contract each year -- but there is no requirement that the company must match prevailing market interest rates when it resets its contractual rate.  Indexed annuities will reset the rate each year based on market rates of return, but those rates are based on the returns of the stock market, which tend to be far more volatile than general interest rate fluctuations.


Purchasing power risk, or inflation risk, was discussed in detail above.  This is the risk that the value of the dollars that are eventually returned to the investor will purchase fewer goods and services than could have been bought at the time of the original investment.  Even modest rates of inflation over a long period of time can seriously erode purchasing power (e.g., 4% annual inflation over a 20-year period will cut the purchasing power of the dollar in half).  While there is little the investor can do about government policies that cause inflation, he or she can minimize its effects by investing short-term, that is, don't give inflation a long opportunity to cause damage.  For annuity investors, however, this is not an option as annuities (deferred annuities anyway) are inherently a long-term investment.  Fixed annuities, with a fixed rate of return, are most vulnerable to the effects of inflation.  Indexed annuities and variable annuities may provide some hedge against purchasing power risk.


Credit risk is the risk that the person or institution holding your money becomes insolvent and will not be able to repay investment.  For the most part, life insurance and annuity companies are financially stable and failures of large insurers are rare. Ratings organizations assess the financial strength of insurers although in light of recent troubles on Wall Street, advisors should be aware of the shortcomings of the ratings system.   State insurance regulations require companies issuing fixed annuities to maintain adequate reserves to meet their obligations, invest prudently and submit to periodic examinations to assure the public that the companies remain financially solvent.   Variable annuity holders don't enjoy such protections.  The sole source of protection for a variable contract is the value of the assets held by the separate account.  As was noted earlier, the separate account is segregated from the firm's general assets, so in the case of insolvency, there are specific assets earmarked exclusively for the variable contractholders.


Market risk is the risk that the general stock market may experience a downturn, generally as a result of the natural progression of the economy through the business cycle.  This is sometimes referred to as "systematic" risk.   Studies have found the more than one-half of the change in any company's stock price is the result of general market conditions.  In a bull market most stocks advance, in bear market most decline.  (One can argue whether that that is a tautology, but the fact remains: when times are good, most stocks benefit, when times are bad, most stocks suffer.)   Fixed annuities are immune from market risk, as their returns are based on a fixed, guaranteed rate of interest.   Variable annuities are very susceptible to market risk.  To a certain extent, some general market risk can be minimized by the selection of actively managed separate accounts.  Some investment managers may be able to overcome general market downturns by outperforming the market.  Passively managed separate accounts (and exchange traded funds, or ETFs) will be more subject to market risk, since they are designed to closely mirror the ups and downs of the general market.   Indexed annuities, which links a minimum guaranteed rate of return with returns based on a measurement of the general market, are perhaps the best solution to address market risk.


One last risk, legislative risk, applies particularly to insurance and other tax-advantaged investments.  Congress grants insurance and annuity products special tax treatment primarily tax-deferred growth.  That special treatment is subject to political considerations.   The tax code is under constant review and revision.  What Congress grants, it can take away.   Investors who may invest today based on the promise of tax advantages may find those features altered in the future.  In the past, Congress typically “grandfathered in” old tax regulations for existing contracts when it changed the tax code, but that may not necessarily be true for any future changes. 



Creditor Protection


We live in a litigious society. High profile clients, with presumably "deep pockets", are obvious targets for lawsuits.  Some professions, such as the medicine, are more susceptible to malpractice or other legal proceedings.  These types of clients may want to consider certain types of investments that offer a greater level of protection from the claims of creditors than do other assets. Sometimes the federal Bankruptcy Code provides this heightened level of protection, other times it is provided as a result of a state's laws.  The most obvious examples of protected assets are the debtor's homestead, retirement plans (including IRAs), life insurance and annuities. The law offers this protection because certain assets are considered essential for the debtor and the debtor's family to maintain at least a minimum level of financial well-being and thereby avoid becoming a burden to the state. The extent of such creditor protection is, of course, tempered by society's proper concern for the creditor's competing rights to access the debtor's property for the satisfaction of legitimate claims. 


The protections provided by the federal Bankruptcy Code apply nationwide -- otherwise the level of protection varies widely, state by state. Florida generally offers unlimited creditor protection for proceeds of life insurance and annuity contracts.  Other states may restrict the amount of that protection to amounts "reasonably necessary" for the support of the debtor and his or her dependents, some states will limit protection to a fixed dollar amount of each month's annuity payments, and still others offer no protection at all.  


In Florida, creditors of an annuity contractowner may not attach or garnish the cash values or other benefits of an annuity (or insurance policy), unless the contract was obtained for the benefit of the creditor.  If the annuity company releases the cash value to the contractowner, however, the creditors may bring judgment against the contractholder for the released proceeds.   The same applies to death benefits paid to the estate of the contractholder.  Once released to the estate, the creditors of the deceased contractholder can claim the death benefits.  The estate is protected against creditor claims only as long as the annuity company holds the proceeds.    Proceeds released to a designated beneficiary (other than the estate) cannot be attached by the contractholder’s creditors.


Contractholders can protect death benefits from the claims of the beneficiary’s creditors by having the annuity company hold the benefits. This provision is known as the spendthrift trust clause. More precisely, this provision shelters proceeds that have not yet been paid to a named beneficiary from the claims of either the beneficiary's or contract owner’s creditors.


The spendthrift clause does not protect to proceeds paid in one lump sum – it only applies if the proceeds may be held in trust by the insurer and paid to the beneficiary in installments over a period of time. Generally, the clause states that contract distributions payable to the beneficiary after the contractholder dies are not assignable or transferable and may not be attached in any way.




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