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Taxing Prosperity

Since both life insurance and annuities incorporate so many tax advantages for investors and beneficiaries, sponsors of annuities feel their product deserves similar deference.

By Jeffrey R. Kosnett, LAN Editor

Issuers of variable annuities know they hold the keys to millions of Americans' retirement dreams—$870 billion worth at last count. But tax issues, especially, continue to dog the remarkable sales success and design enhancements to what has become the supplementary retirement plan of choice for so many self-employeds, early retirees, and baby boomers. Will the tax treatment of VA payouts change? If so, how? And if not, will investors really get bent out of shape? Just what does the future hold for this soaring product category?

It’s not literally a turning point, because the 1990s went one way for sellers and manufacturers of variable annuities—straight ahead. But when word emerged last summer that lobbyists for the annuity and life insurance industries would not only defend the tax-deferred compounding of VA assets but seek capital gains status for at least part of accumulated earnings when drawn as income, the news seemed like a fitting cap to the decade. Only an established force mounts an offensive.

Tax lobbyists say there’s no sign yet the annuity tax rules will change. If they do, it surely won’t be right away. The American Council of Life Insurance strongly supports this, but it has put other tax issues higher up on its list for late 1999 and maybe for 2000. Also, a few months ago, the IRS declined a request by the Fortis insurance company for a private letter ruling that would have eased the tax treatment of a new Fortis annuity product’s income payments.

But this is clear: As 2000 arrives, variable annuities are no longer a poor relation to life insurance policies. Since both life insurance and annuities incorporate so many tax advantages for investors and beneficiaries, sponsors of annuities feel their product deserves similar deference.

This desire for equality is evident from strong VA net cash flows, the company names with "life and annuity," home office directives that all advisors get securities licenses, the stream of new VA features, and a stunning forecast by the Society of Actuaries that in the first decade and first half of the 21st century, assets of life insurance companies will grow much faster than life insurance in force. Some analysts have even begun to compare VAs to mutual funds by rate of asset growth. That would have been ridiculous 10 years ago, when, according to Cerulli Associates, a Boston financial services market research and consulting firm, VA assets under management were $27 billion, or just about equal at the time to industrial (debit) life insurance in force. Talk about an emergence!

Annuities remain controversial with some personal finance writers and financial planners. There is no question that buyers and some advisors who sell them still misunderstand some of their features. The National Association for Variable Annuities is starting a public relations campaign to get its member companies to simplify annuity terminology in advertising and on web sites and in public presentations; for example, saying "converting savings to income" instead of "annuitization," and "for the lifetimes of two people" instead of "joint and survivor annuity." Simplified prospectuses and plainer wording, though, still collide with annuity companies’ self-inflicted product-design complexities like GRIBs (guaranteed retirement income benefits) and MVAs (market value adjustments).

The explosive growth in assets and in sales thus demonstrates that many people who sell financial products are just skilled at selling, whether or not they comprehend every nuance and regardless of whether they work for an insurance agency, a bank, a wirehouse, a credit union, or for themselves. The annuity boom also owes a lot to an accident of timing. The accumulation of close to $1 trillion in VA assets reflects how the product came along on cue to absorb gobs of loose money from people forced out of jobs in middle age or whose employers downgraded their pensions. Another part of the VA sales boom comes from the self-employed "free-agent nation," people who quit jobs and only later realize they no longer have company-subsidized retirement or profit-sharing plans.

The emergence of the annuity industry as its own world is therefore a story of national prosperity, changes in employment patterns, 17 years and counting of a bull market, and demographics, plus annuity companies’ and representatives’ marketing prowess. It’s logical to expect the course of the VA business in the next 10 years to follow what happens in the economy, the job market, and to stocks and other investment categories.

Meanwhile, the annuity business includes several other subplots:

Endless new product offerings and designs. In the 1990s, VAs evolved from basic contracts with few choices beyond an insurance company-run account called “stock” or “bond” and a fixed money-market option to veritable name-brand fund supermarkets like Nationwide’s The Best of America and American Skandia’s VA lineup. VAs, like cars, now come with a list of features and extra-cost options, most developed in the last three years. The innovations make annuity products something akin to the menu available to employees enrolled in cafeteria benefit plans. Fortis just introduced an annuity that lets the owner take a predetermined and guaranteed annual income stream without declaring actual annuitization, thus preserving the investor’s control of the principal. John Hancock brought out a new VA series that includes an option that puts new money into the annuity’s balance should the owner need long-term care.

If there’s a thread tying all this, there is and will be in the next 10 years more marketing and design emphasis on living benefits and nursing care protection and guarantees of prior accumulated investment values or income payouts, regardless of separate account performance. Most such add-ons, of course, are optional and cost the investor 10, 30, 35 or even more basis points a year or, if they are "included," possibly more than that. At some point, if a buyer takes everything, a VA can cost around 3 percent annually, considerably more than just about any brokerage can really charge nowadays for a wrap account, not to mention more than the rate of inflation or right around the yield on many Vas’ fixed-rate subaccounts.

A nod towards safety. The price, and low returns on fixed accounts, almost force annuity owners to put around 80 percent of their assets in stock or balanced accounts. That, in turn, has advisors and VA marketers convinced there’s a buzz about retirement investors overexposed to market risk should stocks repeat a 1973-style nosedive. So annuity companies are and will keep emphasizing safety nets that let buyers lock in unrealized gains as of certain anniversary dates, bookmark a minimum monthly payout, or withdraw cash when they want without surrender charges or other penalties, except IRS penalties. Such features let producers sell annuities on Ibbotson charts or the investment record of the celebrity fund managers but, at the same time, tell a skittish buyer that a VA, unlike a mutual fund or an IRA, includes numerous safeguards.

Press coverage like mutual funds, meaning both critical and praiseworthy as well as more extensive. At one extreme, a Forbes cover story two years ago called all VAs ripoffs, and earlier in 1999 an agent in Albany, N.Y. threatened to sue syndicated columnist Jane Bryant Quinn after she wrote a column full of unflattering words about agents who recommend VAs for qualified retirement plans. Speeches by regulators on that same subject this past year received wide press attention. Everyone involved in marketing annuities knows the Securities and Exchange Commission and the National Association of Securities Dealers are watching, though what exactly they have in mind is uncertain because of the boom in online trading and other possibly more urgent regulatory priorities.

At the same time, Barron’s and The Wall Street Journal, among other periodicals, have added more space for VA separate account tables as an accompaniment to their mutual fund pages. Expanded databases like VARDS Total Reference make possible some of the sophisticated analysis of annuities that used to be limited to mutual funds. VARDS is readying its own rating system on individual VA contracts and now calculates overall five-year compounded performance rankings for each annuity based on a weighted average of all the separate accounts. You’ll find that figure for many of the contracts in the tables that start on page 82.

The Big Issue: Taxes
There are other annuity issues, though, and the one that’s perhaps the most unsettled is tax treatment. By 2005, when the first baby boomers reach age 59 1/2, or if not sooner, the balance of power among annuity customers will shift from the accumulators, whose priorities are separate account choices and fund performance, to the income-spenders, whose interests are continued control of assets, ease of withdrawals, protection for sums built up before retirement, and bearable taxation of the income they may need to draw for 30 years or even longer after they stop contributing new money. In the first decade of the 2000s, VA sales inflows will slow to maybe 6 percent a year, down from the double-digit growth pace of the 1990s, but cash outflows will rise and so will the taxes paid by investors and beneficiaries.

Fortis’ new Income Preferred Variable Annuity is a good vantage point from which to consider annuity taxes. As Craig Britton, the Fortis "team leader" for variable annuities, explains, Fortis invented this one for people near retirement age who are "undersaved," meaning they have accumulated way less than $500,000. The Fortis marketing materials show a $100,000 single-premium payment.

The idea of Income Preferred VA is to give the customer a combination of current income drawn from the principal and further opportunity for growth by keeping the rest of the money at work. True, that’s sort of like partial voluntary systematic withdrawals, and this is in fact a systematic withdrawal platform. But Britton’s emphasis is on the fixed and guaranteed payouts, which Fortis pegs at 7 percent per year of the total purchase payments.

That is, the investor who has deposited $100,000 and decides to take income can have $7,000 a year guaranteed for 14 years (and $2,000 in year 15.) The rest of the principal stays invested as directed. The 7 percent is Fortis’ arbitrary idea, as “7 percent today is kind of a magic figure,” Britton says, noting that no Treasury securities or bank deposits today yield that much. The 7 percent is not comparable to a bond yield, though, since it’s not set by the financial markets, but by Fortis.

This isn’t annuitization and isn’t irrevocable, because there is no age or life contingency. The same $7,000 a year from $100,000 is available at age 60 or 80 or 90. For this deal, Fortis charges 1.40 percent for mortality and another 45 basis points for investment risk and administration, making this VA a 1.85 percent proposition, before asset management charges. In the more traditional Fortis EmPower annuity, the charges total 1.25 percent. Britton points out that unlike in annuitization, the death benefit stays in place and the owner is free to stop the payouts and so has "flexibility and control." The cost of this F&C falls somewhere between 1.25 and 1.85 percent.

But this tale, or this product even, isn’t about fees. Despite endless press attention to annuity costs, and the significant effect of even a few basis points on long-term compound returns, never mind 0.60 percent, high-fee annuities sell as well as low-fee annuities and always have.

No, it’s about taxes. As any seller of VAs absolutely must know and any owner of one absolutely should, when a non-qualified annuity buyer annuitizes—that is, elects to take scheduled payments based on his or her life expectancy—the tax treatment is favorable because the law presumes the income will continue for the annuitant’s remaining lifespan. The IRS has a formula to pro-rate what part of these annuity payments are tax-free, and it is easy to illustrate how this works. But if the investor makes systematic withdrawals or takes lump sums, the law says all the earnings come out first and are taxable at ordinary income rates.

Fortis thought about this as it developed the Income Preferred VA and asked the IRS for a private letter ruling, hoping for the same tax treatment on Income Preferred VA payments as if Fortis had based the 7 percent payment schedule on life expectancy. Not surprisingly, since the 7 percent is an arbitrary number and not an actuarial measurement, the IRS declined.

Some annuity companies aren’t eager to discuss either taxes or regulation now, figuring there are deals to be made and delicate lobbying strategies to move them forward. Or it’s just an unknown. From the vantage point of St. Paul, Minn., Craig Britton says when asked what the tax people might do about VA payments, “Your guess is as good as mine. I know we are actively involved in trying to influence the government to get the best benefit possible.” C. Randy Williams, J.D., CLU, ChFC, a producer for New England Financial in Denver, says “I have no real feeling on this. Trying to guess what Congress will do is grasping at straws.”

Same As UsualFor Now
In fact, although the boys and girls in Washington say they are serious, producers and advisors aren’t optimistic that Congress or the IRS or some other branch of government will lighten up soon on the annuitants.

Alan Fry, CFP, ChFC, national planning specialist for Lincoln Financial Group in Fort Wayne, Ind., laughs when asked if someday, he thinks income made possible from compounded capital gains nurtured inside annuity subaccounts might be reportable as capital gains.

“Not going to happen,” he replies. Why not? “The government is always looking for additional sources of revenue and they like to beat up on the insurance industry,” Fry continues, even when reminded that the insurance industry isn’t being taxed here, individual customers and beneficiaries are. Fry says he is more confident that larger parts of estates may be exempted from estate taxes.

Gil Dudrow, LUTCF, a wholesaler of annuities for Conseco in Little River, S.C., doesn’t think the income tax issue resonates that much with VA brokers or customers. His favorite annuity selling point is “tax deferral, tax deferral, tax deferral. As long as we have it, the other is not an issue.”

Lewis J. Mann, RFC, a financial planner who runs Mannco Financial Services in Gainesville, Fla., predicts some investors and beneficiaries will get irate about taxes, but only if they lack an advisor who can explain early what taxes the annuity owner will owe upon drawing income and under alternate scenarios.

Mann, who likes both variable and fixed annuities and recommends them in seminars, says “I hate taxes and I do everything in my power to reduce them for the clients.” He has another thought, too, which is that for many advisors, their annuity owners and beneficiaries are not in high tax situations. They are paying maybe 20 percent of their total income as income taxes. That’s equivalent to the current capital gains rate. “Even if the [marginal] tax rate is 31 percent, that only bumps up [the taxpayer’s total tax bill] a little. The other advantages [of the annuity] outweigh that,” Mann adds.

Donald Rohde, CLU, LUTCF, of Beaumont, Tex., just retired after a 42-year career as an agent, a manager, a home office executive, and a trainer. He says the demand for annuities and their complexity gives advisors the chance to prove their worth.

“The key depends on how well the [buyer] was informed at the point of sale and whether there have been annual reviews.”

“It is important that at least once a year, the [agent or advisor] must contact the investor and review the status of the portfolio. If not, the [investor] will be disappointed and will accuse the company or the agent of lying or not being truthful” when heavy taxes come due.

"The insurance companies are using the word advisor now, which means we better be in a position to give advice," Rohde adds. “Investors who have not been serviced will be grossly disappointed. The others will not have any surprises.”

Now, What About Performance?
While fees and taxes are often personal and emotional as well as political issues—and costs and taxes affect the ultimate success of an annuity as a savings device—any assessment also demands a look at the investment results.

If you use figures that include results from way, way back, 20 years or so, VA separate account return figures take on progressively less meaning because the original VAs were wrapped around smallish portfolios of stocks and bonds from life insurance companies’ in-house money management shops. The technology to support massive fund-switching had not come along. The few agents and advisors who had NASD licenses and were eligible to sell variable products were really selling a concept, not modern merchandise.

Then, at first gingerly and by the mid-1990s at full throttle, the insurance companies saw soaring sales demand and began to hire popular mutual fund firms like Janus and Fidelity and T. Rowe Price and Fred Alger to manage VA subaccounts. There’s no mystery why. Stockbrokers sell a slew of annuities, and to their clients, mutual funds and self-directed rollover IRAs are the alternatives, not fixed annuities or permanent life policies. So almost every new VA contract includes at least as many, if not more, "outside" funds than any earlier generation VA the new contract replaces. This won’t change. Money management firms see annuities as a growth area, and insurance companies aren’t going to pay million-dollar packages for star fund managers when they can outsource the job to Janus.

Therefore, as years pass, the multiyear VA performance averages (before fees) will more closely track the largest no-load mutual fund groups’ records. This can be true over short periods as well as long ones. In 1999, an uncommonly narrow market—the indexes are mostly up for the year, but a majority of individual stocks have been inert or clobbered—allowed some of the hottest actively-managed portfolios to make a stunning comeback against indexing. The leading gainers among annuity funds in 1999 are dominated by Janus-managed portfolios. Janus managers have cleaned up as a group in 1999 with huge bets on high-tech champions like Cisco and Dell and America Online. Well into October, Janus funds had posted outsize year-to-date 1999 gains in a poor year for most funds.

Print out an industrywide list of annuity separate accounts and Janus is all over the place as the growth and aggressive-growth leader—in annuities from Penn Mutual, Charles Schwab, Conseco and Aetna and GE Capital and Reliastar and lots of others. Even where the subaccount or the annuity name doesn’t give this away, Janus is apt to be there. Take the Pacific Select Variable Annuity and the account called Pacific Life Pacific Select Growth LT.

Peek under the hood and you find a Janus engine, in this case, Janus as sub-advisor and Warren Lammert, whose day job is managing Janus Mercury Fund, as portfolio manager. Net of fees, this Pacific-Janus subaccount has turned $10,000 into $37,130 in the time $10,000 inflated by the change in the Standard & Poor’s 500, with assumed dividends reinvested, would be would be worth $27,590 and the average annuity growth fund as measured by VARDS $24,150.

Lest you dismiss this as a lucky phenomenon, according to the VARDS database, this Pacific Life subaccount ranks second out of 2,451 for the last two years and 22 of 1002 for five years. Pacific Life has become the seventh-largest VA seller in 1999 (up from 18th the previous year), and it’s one reason why in the first half of 1999, Janus netted an inflow of more than $3 billion to its VA funds. Unless this pace reverses in the late months, Janus should end 1999 with a record annuity deposit intake for any outside money manager, according to Financial Research Corp., a Boston firm that tracks annuity inflows and outflows.

Most producers talk more about the need to save and the tax deferrals than they do about particular funds. Also, there’s a lot of exchanging (replacement) of annuities going on lately, and the underlying suspicion—which salespeople discuss off the record but companies hate to admit—is that certain annuity firms are using first-year bonuses and other inducements to get brokers to move annuity assets. A 1035 exchange is not a hard thing to do—especially if you can convince the investor to move so he or she can own a newer-generation annuity—and nothing stops a company from classifying such transactions "new sales." So the annuity industry’s assets are a better measurement of its growth than company sales figures. And evidently, that borderline $1 trillion is real.

Sales and Ratings
The performance issue may gain more prominence as VARDS joins Morningstar in issuing star ratings on specific contracts and if VARDSÕ overall weighted performance figures catch on with the personal finance press and with planners and brokers and advisors. In August, VARDS issued its initial list of the top 25 VA contracts ranked by overall investment performance for the five-year period ending June 30, 1999.

The total assets of these 25 contracts are approximately $208 billion, or one-fourth of the total. Their new sales for the year 1998 were 26.3 percent of VA sales, and for the first half of 1999, the 25 brought in 23 percent of the new VA money. That suggests no clear trend by the buying public or the sellers of annuities to seek out (or to ignore) those VAs which the best overall, meaning deepest, top-to-bottom, portfolio growth records.

Said another way, of the 25 insurance companies with the highest year-over-year 1999 to 1998 sales ratios, only four: Fidelity, Hartford, SunAmerica, and Scudder/Kemper—are on both the 25 fastest sales growers and the 25 top overall performers’ lists.

Are investors oblivious? Will they change in the new century? Or is all that money where it is because of good salespersonship and a lack of tax-deferred nonqualified alternatives? If so, when the stock market goes into the tank for more than a few weeks at a time, and once the younger accumulators are scarcer than the older annuitants, this business will stop growing so fast. But annuities will still be one big, rich, powerful industry, able to bend congressional ears and speak up for retirees’ interests if it chooses.

The National Association for Variable Annuities’ new tagline for its public relations campaign, Retire on Your Terms (emphasis on the "your") suggests a continuing emphasis on flexibility and control features (meaning guarantees and death and liquidity benefits) and secondary attention to investment performance and money management issues. After all, the annuity companies (for the most part) have outsourced performance responsibility, decided that fees need not fall to keep the money coming, and are watching the age wave and the Social Security uncertainty like cats studying birds.

Never again, for sure, will variable annuities be mentioned in the same sentence as industrial life insurance. The question for the century about the begin is whether they will still be mentioned in the same sentences as life insurance.

 


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