MINI-COURSE SERIES
ANNUITIES Part III
Copyright Š 2012 by Institute of Business & Finance. All rights reserved.
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DEATH BENEFIT VS. TERM INSURANCE Variable annuity death benefits need to be compared against term life insurance. The standard death benefit pays the greater of principal or value upon death. Some death benefits can have an annual cost 1.1% to 1.75% of contract value (the M&E charge). For example, suppose a client invested $100,000 in a variable annuity and the mortality expense was 1.25% per year (or $1,250 per year +/- based on contract value). Is the client really getting $100,000 worth of insurance? Only if death occurs when the contract has dropped to zero. If this same client were a 65-year-old male in good health, term life insurance would cost about $580 a year—far less than the $1,250 imposed by the annuity. There are variable annuity death benefits that lock-in any gain after specific internals, based on contract anniversary date (e.g., every 1, 3 or 5 years). Again, the question becomes what is the expected risk versus what could be protected with life insurance. Furthermore, any annuity death benefit is taxed as ordinary income when received; life insurance proceeds are almost always tax-free.
LONG-TERM CARE RIDER COSTS Since the beginning in 2010, insurers have been permitted to issue long-term care insurance as an annuity rider. The rider premium comes from client’s tax basis. Thus, if a client paid $70,000 for an annuity now worth $90,000, the cost basis would be $68,000—if the rider cost $2,000. There are two tax consequences to this cost-basis reduction. First, annuity owner will pay more in ordinary taxes when the annuity is liquidated (larger gain since cost basis has been reduced by $2,000 in this example). Second, the client loses out on taking a tax deduction for the premiums paid for long-term care insurance. If the investor purchased a separate policy, the deductible amount would depend upon the tax return and client age. On a positive note, clients in poor health might not qualify for an “outside” policy, making a long-term care annuity rider a possible consideration.
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WHEN VARIABLE ANNUITIES ARE APPROPRIATE There are a number of legitimate reasons to use a non-qualified variable annuity. However, a good case can be made that before an annuity is even considered, the client should already be funding any available retirement plans to their annual maximum. Qualified retirement plans and traditional IRAs are usually funded with deductible pre-tax dollars, unlike a non-qualified annuity. Just like an annuity, retirement accounts grow and compound tax-deferred and withdrawals are taxed as ordinary income. The argument for first fully funding qualified retirement plans or investing in any annuity is less valid if the alternative is to buy investments that receive capital gains treatment, which is currently 0% or 15%. The upfront tax deduction is lost, but the lower taxation upon liquidation can offset the tax benefits from a retirement plan. Furthermore, most stock-oriented investments also qualify for preferential dividend treatment, which is also either 0% or 15%, depending upon the taxpayer’s level of income. In the case of fixed-income investments, the case for first using pre-tax retirement dollars is a winning argument (since interest from debt is taxed as ordinary income). However, after qualified retirement accounts and IRAs have been fully funded, it usually makes more sense to use an annuity (for the bond portion of the portfolio) that provides ongoing tax-deferral. With the exception of municipal bonds and notes, annual income from fixedrate instruments is fully taxable as ordinary income. Using an annuity means interest payments avoid current taxation. Excluding the retirement account argument, the decision then becomes whether to use a variable annuity instead of a mutual fund. There are four reasons the variable annuity may be the better choice. First, if certain living or death benefit guarantees are important to the investor. Second, if taxable bond investments are to be made, a low-cost annuity is almost always the better choice, unless interest is from municipal securities (tax-free) or the payments are needed for current income. Third, if you have a client who constantly moves in and out of the market or makes frequent switches within a fund family, the tax sheltering benefit of the annuity is an ongoing benefit. As noted elsewhere, before selecting the variable annuity over an alternative investment vehicle, consider and factor in all of the costs associated with each vehicle. Variable annuities offer many attractive features but the cost, limited liquidity and taxation as ordinary income may outweigh the benefits. Fourth, if the variable annuity includes a living benefit rider (see next section), the investor is able to take a much more aggressive position because of the guarantees—something not found with a mutual fund.
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SAVINGS AND RETIREMENT YEARS The number of years savings can be expected to last is a question worrying many current and soon-to-be retirees. The answer hinges on a number of issues, including how much annual income needed, what inflation does in the future and, most importantly, how long you will live. Researching life expectancy is one way to fill in this blank in their retirement plans. But how is life expectancy calculated and should you put much reliance on it when planning for the future?
Averages Life expectancy can be defined as the average age at which a group of people of the same age and gender are likely to die. It is determined by taking all the ages at which the people in a group are likely to die and then averaging them. Half will die by that age and half will live past it. The most important thing to remember about life expectancy is it does not lock in at birth. As you get older, the age which you are expected to live gets higher because the people in your age group who have died are no longer counted in the equation. For that reason, you cannot just check your life expectancy at age 65 and base your planning on that for the rest of your life. For example, the life expectancy at birth for males born in 1931 was 59. Those who lived to age 30 then had a life expectancy of 67. At 65, those remaining can no anticipate living not two but 12 more years to age 77. And once they reach 70, life expectancy increases to 79.
Life Expectancy Tables Tables showing life expectancies for various groups are used by employers to figure pension benefits, by insurance companies to sell life insurance and annuities, and by taxpayers who are following IRS rules for computing minimum distributions from retirement plans. No two life expectancy tables will be exactly alike. Their data depends on when and how the tables were created, where the death rates came from and whether they have been adjusted to make them more current. For example, some companies still use the "83 GAM" table to calculate how much they need to provide their retirees with a lifetime of monthly pension payments. 83 GAM is based on 1966 data, which was updated with projections to 1983. Other companies use the newer UP-94 table, recommended by the Society of Actuaries, which shows significant increases in life expectancies at most ages. The UP-94 table projects men age 55 will live to age 80 and women to 84½. And someone who is 80, according to the table, can look forward to another 8-10 years of life.
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Plan for Your 90s Life expectancy figures are conservative. According to Dr. Kenneth Manton at Duke’s Center for Demographic Studies, individuals who do not smoke, maintain a healthy weight and keep their blood pressure and cholesterol under control with diet and exercise could live 10-15 years longer than current tables project. If longevity runs in your family, your odds are even better. Unless you have life-threatening health problems, plan on living into your 90s.
CHARITABLE GIFT ANNUITIES People are looking for legitimate forms of tax relief. Additionally, more and more Americans are facing the probability that Social Security will be a completely inadequate "safety net" for their retirement. These concerned people are looking for tax-favored ways to augment their future retirement incomes. Charitable gift annuities (CGAs) provide one solution to these concerns. A gift annuity offers immediate tax relief, and has the potential to provide some tax-free retirement income. In exchange for the gift contributions made to a charity, the charitable institution guarantees a retirement income, either immediate or deferred that can last for the entire lifetimes of the donor and spouse. In addition to the economic advantages, the donor can experience the satisfaction of seeing a part of the proceeds of a gift put to immediate use in a charitable institution.
How Charitable Gifts Work One popular method is the gifting of an irrevocably assigned life insurance policy to a charity. In that scenario, the donor deducts premiums as gifts, and upon the donor's death, the charity reaps a substantial benefit. Variations of charitable remainder trusts are another option for deferred giving. While the donor enjoys the benefit of lifetime income, the charity must wait for the donor's death before taking ownership and utilizing the gift remainder. A CGA, however, which is reinsured with an immediate annuity provides the charity with the advantage of immediate access to a significant portion of its gift proceeds.
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Charitable Gift Annuities A CGA is one of the easiest forms of planned giving. In exchange for an immediate gift to a legitimate 501(c)(3) charity, the donor is promised a specified lifetime income. The exact amount of that gift is agreed upon at inception. Typically, the life income goes to the donor or is shared as a 100% joint and survivor option to the donor and spouse. The arrangement is that simple. There is an agreement of understanding between the donor and charity. The charity's stability and reputation provide peace of mind to the donor. If the charity ceased to make the agreed upon payments, the donor would be a primary creditor against that institution. The maximum rates of return typically paid on these uninsured annuities are established by the American Council on Gift Annuities. The ACGA was established in 1927 as an answer to the "bidding wars" for donor dollars. Meeting each three years, this grouping of a large number of substantial national charitable organizations uses interest and mortality assumptions to set up current actuarial tables. In a traditional situation where the donor dies around his or her actuarial life expectancy, the charity would have paid him a combination of interest and gift principal, which yielded a remainder of 50%. It is that substantial "expected remainder" which helps drive the IRS's acceptance of the CGA as a legitimate gift with well-defined tax advantages. In the event a wealthy donor accepted a rate of return below the ACGA tables, it would pass on an even larger gift portion to the charity at the donor's death. In the event an organization offered rates of return considerably above the established
How Annuity Reinsurance Works Remember that the agreement is for the charity to pay a lifetime income to the donor. Once the agreement is completed, the manner in which the charity invests its assets to carry out that goal is exclusively the charity's business. The organization can take the full proceeds of the donor's gift to a bank's trust department and ask them to manage the assets in a portfolio. The bank, however, cannot guarantee principal will last for the donor’s lifetime. In the event market conditions seriously diminish the value of a portfolio, those continued income payments may cease. Also, in the event that a donor significantly exceeds life expectancy, all the resources of the gift may be exhausted. If the gift proceeds are gone, the charity must reach into other resources to continue lifetime payments. By utilizing annuity reinsurance, however, these risks can be completely eliminated. In a reinsurance transaction, the charity takes the entire gift from the donor and in turn purchases a life annuity from an insurance company with the proceeds. The annuity can be immediate or deferred. The cost of purchasing that lifetime annuity is lower than the amount of the gift.
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In the case of immediate income annuities to donors in their seventies or older, the charity may be able to obtain the life annuities at a 35-50% discount. That spread between gift and purchased annuity represents outright cash that is available today to the charitable institution. The balance can be invested in an endowment fund or used for other purposes. When a donor is concerned about the guarantee of income a charity is making, the annuity reinsurance is a valued dimension helping the donor proceed with the gift. The charity is able to reassure the donor a financially strong insurance company stands behind its commitment to guarantee lifelong income. The charity transfers to the insurance company all interest rate risk, investment risk and mortality risk. The insurance company actuarially assumes all of these risks. In addition, the insurer takes on administrative duties of income payments and tax reporting.
If Donor is Very Old or In Poor Health In these situations, the charity may purchase a life annuity with a period certain guarantee. Such an annuity provides a life income regardless of donor's lifespan plus it guarantees income payments for a minimum fixed period, say 10 years. If the charity is both the owner and beneficiary of the annuity, it could benefit from any unused future guaranteed payments in the event the donor dies within the 10-year guarantee period.
Gifting an Appreciated Asset Younger donors may have an asset that has appreciated considerably. Take the example of a doctor who purchased her clinic in the 1970's for $100,000 and at age 55 wishes to sell her building so she can then go and work as a chief physician at a hospital for the next 10 years before retirement. The clinic's value has appreciated to $500,000. Selling it outright would trigger a $400,000 capital gain. If our doctor gifted this appreciated property to her hospital, the hospital could liquidate it at its current market value with the following results: The doctor would receive a tax deduction based on its appreciated current value and the nonprofit institution would not have to deal with the capital gains tax. The doctor would then be guaranteed an income that not only reflects the current value of her gift, but also its compounded value over the next decade before that retirement income stream commences. The taxes become a little more complex in this case. While the outright immediate deduction is still taken, there will be some recognition of capital gains because the gift was not completed outright—the doctor still reserved the right to future revenue. However, at retirement, she can pay her remaining capital gains taxes on an "installment plan" over life expectancy.
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A part of each income payment would be taxed as either ordinary income or as capital gains. When the remaining capital gains have been paid off over the doctor's actuarial lifetime, a few good things happen: If the doctor is living, her guaranteed life income payments continue; with the capital gains having been paid off, her annuity income stream will be taxed at a much lower rate.
Prospecting for Charitable Gift Annuities The CGA can also be structured to allow for the creation of a life insurance estate upon the donor’s death. If the donor is willing to accept a reduced income stream, part of the donation may be diverted to pay premiums on a life insurance policy. This will generate a death benefit to relatives that could replace the capital gifted to the charity. Or the charity can be named as beneficiary of the life policy to receive the death benefit as a future gift. A gift annuity's yield varies according to age. For example, if you were to set up a $10,000 gift annuity at 60, you would earn $690 a year and deduct $3,733 on your tax return for the year in which you make the donation. The deduction is equal to the gift's present value minus the lifetime income the IRS estimates you will receive. If you were to make the donation at 80, you would get $940 a year and a $5,038 deduction. A two-life gift annuity, which pays income to the survivor for life after the donor's death, offers a slightly lower yield.
The Benefits of Charitable Annuities Most gift annuities follow yield guidelines set annually by the American Council on Gift Annuities; rates are the same for men and women. To estimate what your yield and tax deduction would be on $10,000 gift annuity, find your age below:
Charitable Deduction for a $10,000 Gift Age
Rate
Deduction
50
6.5%
$3,234
55
6.7%
$3,433
60
6.9%
$3,733
65
7.2%
$4,049
70
7.7%
$4,344
75
8.4%
$4,666
80
9.4%
$5,038
85
10.5%
$5,531
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Since a portion of your income will be considered a return of principal, part of your annual income will be tax-free. How much depends on your age. For instance, if you were to make a donation at 60, the tax-free portion would be 38%. If you were to set up a gift annuity at 80, tax-free amount would be 56%. Returns on gift annuities are less than those paid on commercial annuities. For instance, if a 65-year-old man bought a $20,000 single-life fixed annuity from Presidential Life, he would receive $1,910 a year, also partly tax-free. If the same man donated $20,000 to his favorite charity as a gift annuity, he would earn $1,440 a year and get an immediate $8,098 tax deduction. If he donated appreciated stock, he would avoid capital gains taxes. You can start receiving income from a charitable annuity immediately. If you wait, however, your deduction and eventual yield will be considerably higher. For example, if you established a $10,000 gift annuity at age 50 with the Salvation Army and deferred payment for 10 years, you would get a $5,458 deduction and start collecting $1,170 a year at 60. If you donated the same amount at 60 and started payments immediately, you would get $690 a year and a deduction of $3,733.
THINGS TO DO Your Practice Strategies involving charitable giving can look quite appealing, but the reality is few clients ever make such a commitment while either spouse is alive. The other reality is that special riders for fixed-rate contracts are not likely appropriate for the majority of your clients. The Next Installment Your next installment, Part IV, covers living benefit riders. You will receive Part IV in a few days. Learn Are you ready to take your practice to the next level? Contact the Institute of Business & Finance (IBF) to learn about its designation programs: o o o o o
Annuities – Certified Annuity Specialist® (CAS®) Mutual Funds – Certified Fund Specialist® (CFS®) Estate Planning – Certified Estate and Trust Specialist™ (CES™) Retirement Income – Certified Income Specialist™ (CIS™) Taxes – Certified Tax Specialist™ (CTS™)
IBF also offers the Master of Science in Financial Services (MSFS) graduate degree. For more information, phone (800) 848-2029 or e-mail adv.inv@icfs.com. PART III
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