Investors & Objectives
One factor many advisors fail to consider when making recommendations is the sophistication of the investor. Basic investments, such as stocks and bonds, may be relatively easy to understand, while packaged products such as mutual funds and annuities present a more complex situation. As the famed investor Warren Buffet says: "If you can't pronounce it and can't explain it, you probably shouldn't invest in it." Some annuities, such as traditional fixed contracts, are very simple to understand: a guaranteed rate of return, fixed income payments for life with relatively few fees. On the other hand, a variable annuity's investment options, management fees, and varying values are more difficult to comprehend. The myriad moving parts of an equity indexed annuity -- participation rates, spreads, caps, floors, etc. and their complex interactions -- can be damned near indecipherable to the general public (and probably many financial professionals, too).
Regulatory organizations impose a number of disclosure requirements on annuity salespersons. The intent is to educate prospective clients as to the advantages and disadvantages of the annuity product and allow the client to make an informed decision. But if the client is incapable of understanding the product's features, then the product is, per se, an unsuitable investment for that client. If the sales pitch boils down to "trust me", the product most likely will become a future problem for both the client and the agent. In these situations, the client may trust an advisor who may not fully understand the product (after all, he was unable to adequately explain the contract to the client). This puts the client at heightened risk. For the agent, sales made in this manner are ripe for future charges of misconduct -- and any short-term gain from the sales commission may be offset in the long run by much higher losses.
On the other hand, a knowledgeable salesperson who can simplify a complex investment into everyday language opens a wider range of investment opportunities to his or her clients. Just because an investment is complex or difficult to explain does not necessarily make it a bad investment. Very few people understand the detailed workings of electronic ignition switches, but this does not keep them from starting their cars in each morning. Advisors should simply be aware of the challenges of educating clients so that they understand the risks and benefits of the proposed product. In the case of complex products such as variable and indexed annuities, that educational process simply demands more time and patience from advisors — first to adequately educate themselves and then to communicate that knowledge to their clients.
That said, if a client doesn't understand what they are investing in, then the simplest and clearest path for both the client and agent is "just say no".
Annuities can be useful tools for estate planning purposes. In these cases, it is not uncommon for the client to be an estate or a trust -- not an individual. Ownership of annuities in these types of accounts may pose special opportunities and challenges to the financial advisor. Generally speaking, living trusts (or inter vivos trusts) have the same investment objectives as "regular" individual clients discussed above: accumulation, conservation, distribution and transfer. Estate clients and testamentary trusts will most likely focus on the latter two objectives: distribution and transfer.
One of the estate planning reasons for purchasing an annuity is that the annuity's benefits are available directly to the designated beneficiary in the event of the contractholder's death -- that is, they are not subject to the delays and costs of the probate system. While this is true, other investments also can be structured to avoid the cumbersome probate process -- joint ownership, pay on death accounts, or ownership within a retirement plan or trust. So while annuities (and life insurance policies) will bypass probate, that is not a sufficient reason, by itself, to invest in annuities as opposed to other investments.
Fixed, deferred annuities provide three useful guarantees to the estate planner: guarantee of principal, guaranteed minimum rate of return and guaranteed annuity payout factors. These guarantees provide a minimum return and minimize the client's exposure to interest rate risk. Changes in the general level of interest rates will not affect the value of the annuity — the full value of the investment is available for withdrawal (which may be subject, of course, to surrender charges). Variable deferred annuities do not offer such guarantees during the investor's lifetime — but the minimum guaranteed death benefit could provide assurance to the investor's heirs. Enhanced death benefits may provide additional comfort, locking in investment gains over the investor's lifetime or providing a minimum rate of growth in the death benefit. These can be important when the amount to be passed to heirs is a important estate-planning goal. Older clients are often wary of putting “too much” into the stock market, and the guaranteed death benefit may make the decision to invest in equities more palatable. This may allow the client to comfortably invest more heavily in stocks to provide a better returns (or a greater inheritance to heirs) than could be earned from more conservative investments.
Likewise, the creditor protection aspect of annuities may be a useful feature to the estate plan. Unlike other assets, which might be attached by the deceased's creditors, proceeds of an annuity contract are protected (to some degree) in most states. With some forethought, a person can also protect the value of the annuity from the creditors of the annuity's beneficiary.
One common goal of many estate plans is to provide periodic income to heirs — and annuities can provide an ideal way to achieve that goal. The estate plan may leave it to the estate's executor to purchase immediate annuities to fulfill that desire upon the client's death. Or a client can purchase a deferred annuity during his or her lifetime to accumulate and conserve wealth with the intention that the contract be annuitized and payable to beneficiaries after his or her death. Annuities are unique in that they are the only investment vehicles that can guarantee an income for the beneficiary's lifetime. Surviving spouses like to know that they cannot outlive their incomes, and the lifetime guarantee can comfort parents of special needs children that income will always be available for their continuing care. The greatest drawback of annuities for this purpose is that once the periodic income payments begin, they typically must continue unmodified into the future. This lack of flexibility can be a disadvantage when annuities are compared with other alternatives to provide an income for beneficiaries.
Annuities can also be used to address another estate planning dilemma: how best to invest estate assets to provide different types of benefits for different classes of beneficiaries? For example, a husband wants his estate to provide income for his surviving wife and pass remaining principal to his children by a previous marriage. (In today's society of blended families, this is becoming an increasingly common situation.) The widow will want to maximize income production; the children will want to invest for capital appreciation. How does one reconcile these two incompatible goals? A portion of the estate could be used to purchase an immediate annuity to provide an adequate income to the widow, while the balance is invested for growth. Investment setbacks in the growth-oriented assets will not affect the widow's income, nor will income payments taken from the annuity affect the children's portion. The key to this strategy's success relies how large a portion of the estate must be paid to the annuity company to provide an adequate income — and that, in turn, depends on the age of the income-receiving beneficiary (and the widow's definition of "adequate", of course). Annuities will pay a higher periodic payment to older beneficiaries than younger ones, all other factors being equal. The premium to pay an adequate income may be reasonable if the widow is older, but if she is relatively young, the premium for the annuity may be prohibitively high. Another concern may arise. Remainder beneficiaries might view the purchase of an annuity as protection from having to pay the entire estate to their stepmother if she lives a long time or if investment income can't cover annual payments -- but what if she dies shortly after their father? In that case, the portion of the estate used to buy the annuity is "wasted" in the eyes of the children. A survivor benefit (e.g., 10-year period certain) would solve that perception, but that protection comes at a higher cost.
The foregoing assumes that the primary objectives of the estate-planning client are to distribute and transfer wealth after death — and as we've seen, annuities can be a direct help in that regard. But just because a client is contemplating transfer of their wealth after death does not mean that they are not concerned with their standard of living during their lifetimes. That concern can impinge on effective use of lifetime estate planning tools -- such as the annual gift tax exclusion. One of the prime objections that many people have to giving substantial gifts during their lifetimes is "I might need that money". If the client and his or her spouse had a guaranteed lifetime income, that objection might be more easily overcome. The client could transfer more of the estate's value during his or her lifetime, at a lower tax and administrative cost, and perhaps with greater emotional satisfaction. Lifetime gifts also give the donor a chance to see how the gifts are used and whether the post-mortem plan needs to be modified. (Likewise, the various enhanced living benefits -- GMAB, GWIB and GMWB — may assuage the investor's need for lifetime income and make a program of lifetime gifts more attractive. Whether the additional cost for these benefits is justified is a personal decision based on financial and nonfinancial considerations.)
Lastly, annuities provide a mechanism to defer taxes even after death. Taxes on the earnings within an annuity are not payable until they are distributed. Periodic annuity payments are only partially taxable — each payment is effectively part taxable income and part tax-free return of principal (the "exclusion ratio"). This is true of annuity payments to the investor during his or her lifetime as well as annuity payments made to beneficiaries after death. Meanwhile, earnings in the account continue to grow tax deferred during the annuity period. That tax deferral can be extended past death by use of a "stretch annuity". A stretch annuity is simply an annuity contract that sets the beneficiary designation such that eventual payments must be paid out to beneficiaries in the form of periodic annuity payments (not lump sum withdrawals). This can result in continued tax deferral of earnings in the account long after the investor's death. In the case of spousal beneficiaries, the surviving spouse can "step into the shoes" of the deceased investor. In turn, the spouse can name new beneficiaries, which will extend tax deferral period even longer. As noted earlier, this use of the beneficiary designation can also act as a "spendthrift clause" to protect the beneficiary from this or her creditors' claims. In a way, the annuity operates like a trust, limiting access to the underlying assets (although trusts, by their nature, can be far more flexible if that is an important estate planning goal). Some issuers offer appropriate language in their beneficiary designations to take advantage of the stretch concept, others do not.
Now let's turn our attention to various annuity prospects other than individual purchasers.