Jose Luis Pelaez Inc | Getty Images
The days of an advisor selling an annuity to a client, nabbing a fat commission and never seeing him again are over.
Or at least they should be, if you’re doing it right.
Annuities — fixed, variable or indexed — have been long a part of advisors’ toolkits, offering clients the opportunity to obtain tax-deferred growth and income in retirement for a cost.
Investors can also opt for extra features in the form of living benefits, which may provide them with additional income in the future.
While those attributes might be enough to get pre-retirees curious about an annuity, advisors say that working these products into a client’s portfolio is a long-term process.
“I would say 2003 to 2009 was the golden age on getting 6% withdrawals on these things for the rest of your life.
vice president of investments at the Starner Group of Raymond James
That means every annuity recommendation must consider the overall portfolio allocation of a given client, his retirement goals and the appropriate time to tap the contract for income.
Even taxes are key considerations when an annuity is in the mix.
“It’s less of a transactional business,” said Jessica Rorar, a certified financial planner and director of investments and financial technology at Valmark Financial Group.
“It’s more of a concierge service where you’re keeping up with required minimum distributions, turning on income riders at the right time and making sure that the cash flow is there for the retiree,” she said.
Servicing old contracts
Hero Images | Getty Images
Living benefits, including guaranteed minimum income benefit riders, helped propel variable annuity sales prior to the 2008 recession. In 2007, a total of $179.2 billion in variable annuity contracts were sold, according to Morningstar.
These benefits give clients a growing stream of income they could tap in retirement.
The living benefit itself isn’t hard cash. Rather, it’s a notional value that would increase over time and that the insurance company can use to calculate income for a given client.
The prospect of income for life meant that clients could invest more heavily in equities within their annuity and more conservatively elsewhere within their portfolio, according to Rorar.
“I would say 2003 to 2009 was the golden age on getting 6% withdrawals on these things for the rest of your life,” said Bruce Cacho-Negrete, a CFP and vice president of investments at the Starner Group of Raymond James.
Those perks were ultimately too much of a good thing for insurance companies.
Sharp declines in equities in 2008 left clients with low account balances in their annuities, while insurers remained on the hook for paying out those living benefits.
Insurance companies, eager to get those liabilities off their books, stopped offering rich benefits and sought to buy out investors’ existing contracts.
Since then, advisors have continued to service those annuities, noting that these benefits are now an integral part of the client’s retirement income plan.
“It’s the income characteristics,” Cacho-Negrete said. “If you get caught by bad sequence of return risk, in the worst case, you can still draw 6% income.”
Klaus Vedfelt | Getty Images
Even if a contract can offer multiple features, advisors should be judicious about which ones they recommend.
“Some advisors try to get the annuity to do everything,” Scott Stolz, president of Raymond James Insurance Group.
“They’ll add a living benefit, a death benefit and the contract also grows tax-deferred,” he said.
Here’s the catch: The more benefits you add, the higher the cost for the consumer. High expenses dampen returns.
For instance, the average all-in cost of a B-share variable annuity is 2.366%, according to Morningstar.
Tack on a living benefit, and the fee rises to 3.35%. A death benefit will run an additional 0.604%, Morningstar found.
Depending on the client’s circumstances, advisors have opted to avoid living benefits altogether on fixed and indexed annuities.
“There are two things going on: You’re reducing equity exposure, so the indexed annuity is being used as a fixed income alternative,” Stolz said. “And it’s not an income play — investors just want to take the money off the table.”
Being tax aware
In the same way that tax planning is a component of an overall financial plan, advisors should bear it in mind when they recommend annuities.
The tax treatment of annuity withdrawals boils down to how the investor funds the contract.
It’s key for clients to know that if they are using individual retirement account assets to fund an annuity, they will face income taxes on the entire amount distributed from the contract.
Advisors will also need to consider that those retirement assets are subject to required minimum distributions after a client turns 70½.
“A majority of people should turn on the income rider by age 70,” Rorar said.
Those who use after-tax dollars, perhaps from a brokerage account, face taxes on the investment gains within the contract. These earnings are taxable at ordinary income rates, which are as high as 37%.
If an investor merely withdraws a lump sum of cash from a non-qualified annuity, the earnings come out first and are subject to income tax.
Meanwhile, if that client annuitizes a non-qualified annuity — that is, he receives a steady stream of income from the contract — a portion of each payment will be considered a tax-free return of premium, while the rest will be considered taxable earnings.