Update to the Problem With Annuities
The Problems with Annuities – 2013 Update
With 2013 now behind us, we wanted to update our comments related to planning and tax problems with annuities (See The Problems with Annuities – Part I and The Problems With Annuities – Part II). The goal of this paper is to provide some comments about annuities , the industry and related matters that occurred during 2013.
Annuity Contract and Product Changes
With 2014 upon us, a natural goal that we hear about (personally, professionally, business) is change. There were a number of annuity contract and product changes impacting the industry in 2013. We have written previously about a major problem we have with annuities – that the contracts are not guaranteed and changes can be made to products at the discretion of the insurance carrier (spoiler alert – many times these changes do not benefit the contract holder but do benefit the insurance carrier). For ex ample, in the first quarter of 2013, carriers were busy making changes to existing products, particularly in the area of fees, revising step-ups and withdrawal percentages. Carriers filed changes to 97 annuity products in the first quarter of 2013, compared with 101 filings during the fourth quarter of 2012 and 59 in the first quarter of 2012 as an example. As reported by Financial Planning magazine (July 2013 issue), the changes were to reduce living benefit guarantees (a key sales pitch item) and constrain risk (risk here is risk to the insurance carrier and their profits on these products, not investment risk).
Because the name of the game on annuity products is to maximize the return to the insurance company, 2013 saw a number of cash buyout offers being extended to current annuity owners due to lack of profitability or risk exposure to the carrier. For example, Hartford offered a cash buyout to current Direct M and Leaders Series contract holders during 2013. Owners of their Lifetime Income Builder II rider were offered the greater of the contract value on the surrender date or, if the account was underwater, the contract value plus 20% of the benefit base (with the total capped at 90% of the benefit base), as reported by Financial Planning magazine. Not only are annuity products complicated to price shop and analyze, but in 2013 owners had to analyze whether or not to accept cash buyouts, which are also complicated. Who will help the annuity owner prepare the complicated analysis – the salesperson? Our experience is that the salesperson cannot do this type of analysis and many times cannot be found after the sale.
Another troubling change surfaced in 2013 – picking on Hartford again as an example, carriers started applying a series of new restrictions to existing contracts. In Hartford’s case, in mid 2013, they looked to place investment restrictions on existing account balances for a number of contracts. Certain clients with Hartford’s Lifetime Income Builder rider will need to switch to a number of more conservative investments. Options include a menu of funds that call for a minimum 40% allocation to fixed income. Clients who did not respond by October 4, 2013 could have their rider terminated.
Hartford declined to make any executives available to be interviewed for the story summarized above ( Investment News, June 24, 2013).
We discussed in Part I of our annuity series that regulators like FINRA (who is responsible to oversee the salespersons selling variable annuities) are concerned about the “hard sell” (their word s) pitched to prospects, including the typical focus of the sales pitch on the emotional aspects of investing and talk about “guarantees” (which are not really guarantees as noted above).The trade publication, Investment News, reported in its late June 2013 issue, that regulators were starting to look closely at the provisions in variable annuity (VA) contracts that allow insurers to prohibit future contributions or make changes to how those contributions are invest ed. The Securities and Exchange Commission (SEC) is worried, as reported by Investment News , that life insurance companies are taking advantage of vague language in VA contracts to make substantial (emphasis added) changes that could hurt investors. For example, in some cases individuals have bought annuities under the impression that they would be allowed to make additional payments, only to find out several years later they could not! Wait a minute – so, the individual gives money to the carrier and then wants to add to their investment account within the annuity and carrier says no? Unfortunately, this has happened:
“You see a moving target where the original prospectus might have had disclosures that say, ‘We reserve the right to limit purchase payments’, and it might have been worded in a way that suggested [that the insurer] could reject something that was not in good order,” said William Kotapish, assistant director of the Office of Insurance Products at the SEC. “That’s frustrating the reasonable expectations of the investor.” We could not agree more.
The 2008-9 financial crisis had a big impact on investor psychology. The financial crisis was the second time in 10 years (the first being 2000-2003) that investors had to deal with large price declines in equities. For those close or just starting retirement during those time periods, the price declines materially depleted portfolios. Investors are increasingly looking for a magic bullet so that their golden years do not turn to brass.
We talk with our clients about having an investment and financial plan, including a spending plan, to address their concern–a plan that is based on analysis, not emotion. A plan that is unique to the individual’s goals and objectives. For the investments, we talk about a proper asset allocation plan that is responsive to the goals and objectives. We want the client to keep all the returns provided by Mr. Market (whether equities or fixed income). As an independent, objective, feeonly register ed investment advisor, we know this strategy and approach works for many people. However, salesmen (who are not independent, objective, feeonly professionals) use the market periods noted above to sell annuities as the way to address financial concerns. Not only are we concerned about this trend, but so are consumer advocates who also have been ringing the alarm bells in 2013 about the more complex annuity products and their appropriateness for retirement funding.
Although annuities sound good in theory – the ability to get a retirement income stream over years, instead of dealing with lump sum amounts – their various features and riders can provide more limits than security. The complexity of these products make it very difficult to comparison shop as well.
Barbara Roper, director of investor protection at the Consumer Federation of America, mentions a number of factors that clients and advisors should be aware of when considering an annuity product in an Investment Advisor March 2013 article:
1. A huge percentage of annuities are held inside tax advantaged retirement accounts, so the individual has purchased a product whose primary benefit are tax advantaged, inside an account that already provides those tax advantages. (Editorial comment: we talked about this problem in our prior writings. In addition, the SEC has said in the past that this sales tactic is questionable and not appropriate for a retirement product).
2. Complexity – when you buy an investment, you should not do so unless you understand what will have to happen for you to make money and lose money. Per Barbara, too often annuities—at least the more complex, exotic annuities– fail that test.
3. Annuity products are hard to compare because they are so complex in terms of the different features they have: minimum withdrawal benefits, guaranteed lifetime payouts, etc.
4. Lack of disclosure about the maximum penalty for early withdrawal in an equity indexed annuity prospectus. These types of annuities tie up the individual’s money for years. Per Barbara, knowing the downside of these annuities is an algebraic equation – “i equals that, j equals that and m equals this. So, they’ve disclosed the calculation that determines the withdrawal penalty, and there’s not one investor in a thousand who would look at that and have a clue what the penalty might actually be.”
5. Annuities are high cost products.
6. Annuities are sold by salespeople who don’t have to act in your best interests.
Barbara ends the article with a very insightful comment, “Market forces are not operating here. If people who have expertise can’t compare the products and determine what’s best for a particular investor, it means the products don’t have to compete based on being best for the investor. They compete based on paying the salesperson. That to me is a market I want to avoid.” Barbara, we could not have said it any better.
IRA Annuity Traps
We commented in our previous writings about how often we see annuity products inside an IRA or other tax deferred accounts. To us, this makes sense on some level, since that is where the investor money typically is. Individuals typically have the bulk of their retirement assets in tax deferred accounts – since that is where the money is and since the salesperson is not an independent, objective advisor, it makes sense to close the sale and use tax deferred money. No 2013 annuity update would be complete without discussing IRA annuity traps and the comments below are from noted IRA expert, Ed Slott, from his October 2013 newsletter.
1. Using the wrong value to calculate ROTH Conversion Income or Required Minimum Distributions (RMDs). As CPA’s here at River Capital Advisors (RCA), we know IRA valuation is critical in order to compute RMDs. It is also critical for ROTH conversions because the tax cost is determined based on the fair market value (FMV) of IRA assets. As Ed Slott notes, valuing certain deferred annuities can be tricky since many of these products have a number of different values (which in our experience causes other problems, such as the individual understanding exactly what the annuity value is) such as accumulation value which might represent the FMV of the assets held within the annuity (which might differ from the FMV of the entire annuity). There may also be a separate value for an annuity benefit, sometimes referred to as the benefit base or rider value. Neither of these values may be acceptable for an IRA valuation notes Slott.
2. Don’t Fall Into the “Spring-Back” Annuity Scam. Most annuities have some kind of surrender charge for a time period, assessed by the annuity company. Per Ed Slott, in the past there were a number of promoters that offered deferred annuities with an extraordinary surrender charge, with some as high as 99%, that would vanish after just a short period of time. Why would anyone sell (or buy) this product, you ask? To take advantage of a perceived loophole in the tax law, per Slott. Under the tax code, a ROTH IRA conversion is treated as a distribution from a traditional IRA followed by a rollover contribution to a ROTH IRA. So, a literal reading of the law indicates an opportunity – if there is a $100,000 deferred annuity in an IRA, which is converted to a ROTH and the annuity has a 99% surrender charge, then surely the conversion of the $100,000, less the 99% surrender charge (leaving $1,000) is the taxable amount, converted to a ROTH. Then, later, when the surrender period ends and the annuity value “springs back” to $100,000, this is tax planning nirvana – $1,000 taxed that turns into $100,000. As CPA’s, we know the IRS does not see it that way (see IRS regulation 1.408A-4).
3. RMDs After An IRA Is Annuitized. This trap applies to IRA annuities that have been annuitized. So, how will RMDs be calculated after annuitization? Not so simply if there is more than one IRA and an annuity is involved. There is some debate, per Slott, over whether or not a distribution from an annuitized annuity can be used to satisfy RMDs for other IRAs in the year of annuitization. In light of the grayness in this area, the individual needs to talk with their CPA about how to handle RMD payments in this situation. After the year of annuitization, the computations are much clearer. As Ed Slott notes, most experts agree that there is no way to use the income from an annuitized annuity in a separate IRA (the sole asset of the IRA) to offs et any RMDs for another IRA (that does not have annuities in the account). In this situation, the annuity payout is the RMD for the one IRA account and a separate RMD would be computed for other IRA accounts. This may mean that your total RMD for your accounts will now be higher than it was previously.
4. Partial ROTH Conversions and Recharacterizations May Not Be Possible. We work with our clients to execute partial ROTH conversions and to utilize the ability to recharacterize some or all of the partial conversion by the due date of the tax return, including extensions. However, as noted throughout this update, annuities are complex and they add complexity to this tax planning strategy. Often times, annuity companies do not allow clients to split contracts, which would generally be necessary in order to make a partial conversion and/or recharacterization. As a result, clients with IRA annuities that want to do a ROTH conversion and/or recharacterization might face an all or nothing decision if an annuity contract cannot be split. We recommend individuals check with the annuity carrier about splitting a contract before executing a partial ROTH conversion.
Resources and Additional Information
Below are links to additional information regarding annuities from others that should be reviewed by anyone who owns or is being pitched annuities:
The State of Florida has legislation that used to be focused solely on the elderly regarding annuity suitability; they have since ratified legislation extending that protection to ALL ages:
Even NBC’s Dateline waded into the discussion with its “Tricks of the Trade” piece
We hope you found this annuity update helpful. We recommend you read our two other white papers on annuities, The Problem with Annuities Part I and II. Although an annuity can have a role in a financial plan under certain situations, many times what the individual needs is a plan. As we like to say, hope is not a plan, buying a financial product is not a plan. A plan needs to be specific to an individual’s unique financial goals and objectives, encompassing their investments, spending, asset allocation and taxes. We want our clients to keep all that the markets offer, consistent with the clients risk tolerance. A plan should not be based on emotion, it should be based on analysis. The goal of RCA is to make a difference in the financial lives of our clients. Please contact us if there are any questions on this article or if we can help you in any way.
River Capital Advisors, L.C.