Annuities Can Pilot Retirement Plans
by Thomas Scott

As a pilot of 30 years, I’m accustomed to preparing for the unexpected. Anyone who is trained to fly knows you can never assume anything when it comes to flight planning and safety. As a financial advisor, it strikes me there are some interesting similarities between airline emergency planning and retirement planning.
A little history: As a crewmember of the first-ever 747 jet crash in 1974, the planning and emergency training I received from Lufthansa allowed me to avoid panic, keep focused, and help save 90 of the 149 passengers from a mountainside in Nairobi, Kenya.
It was an unnerving experience, to say the least. After we plunged into the mountain, the bottom of the first-class cabin collapsed. Once I realized I was uninjured, I unbuckled and began helping passengers evacuate. Making one final run up the aisle to make sure I hadn’t missed anyone, I heard a moan from under some rubble. There I found an elderly man, bleeding and gasping for breath. I pulled him out the emergency exit just as a secondary explosion ripped through the cabin.
We struggled to an area about a hundred yards away, joining other evacuated passengers and crewmembers. Just as I took a deep breath of fresh air, I spotted a woman in the doorway we had just exited. She was frantically waving and screaming for help. I ran back and when I tried to pull her from the wreckage, I saw a seriously injured passenger -- her husband -- sprawled on the cabin floor next to her, unable to move. Together, we managed to drag the semiconscious man down the chute. We were, perhaps, 30 yards away from the burning wreckage when a final series of explosions engulfed what remained of the huge jet in flames. We were the lucky ones, alive at least in part, because of my emergency training.

Keeping Fingers Crossed

Today, as principal of a financial advisory firm in Orange County, I often see people adopt a “hope for the best” approach to their retirement planning, much as some people keep their fingers crossed on flight takeoffs and landings.
Yes, people put some money aside during their working years and have pensions, 401k plans and the like. But, most lack anything resembling a cohesive plan. They don’t really know how much money they will have for retirement or even how much they will need. Most have bloated investment return expectations. Virtually everyone fears outliving their assets.
It’s easier for people to avoid thinking about the ramifications of retirement than to conduct a comprehensive assessment with a financial professional. Until recently, the products available for advisors to help clients confidently meet their retirement needs were somewhat limited. Increased market volatility and longevity also made planning more complicated.
Lacking adequate planning and the ability to accurately predict and ensure retirement income streams, most people adopt an optimistic attitude while remaining ill-prepared for what advertisers euphemistically described as their golden years.
Much has changed recently as a result

of the emergence of variable annuities with guaranteed living benefit riders available for an extra charge. Advisors now have better options for retirees who are worried about uncertain income streams or outliving their assets.
Today, I encourage my clients to discuss emergency planning for their retirement portfolios. Where appropriate, these discussions revolve around variable annuities with added cost living benefit riders.

A Strategy Based on Confidence

Frankly, I never thought I would be discussing, much less recommending, variable annuities. The products have engendered a widespread negative reputation among the media, advisors, and the public. For years, their use as a retirement planning tool was regarded as little more than a rationale to generate advisory commissions. In short, they were universally condemned.
That lingering perception is not easily changed with skeptical clients. If, like me, you have suggested variable annuities to your clients and had them stare at you like you were trying to steal their wallets, don’t be discouraged. Annuities now available offer some significant advantages. Even some members of the media are revisiting their previous assessments. Once your clients understand the benefits and the potential pitfalls, they are able to make more informed decisions. Many of my clients have become converts to variable annuities with living benefits.
The variable annuities with broadest range of applications for retirement planning are those with guaranteed withdrawal benefit (GWB) riders. These variable annuities address the vital issue of ensuring an income stream for life, regardless of market volatility or overall performance. Clients have flexibility that’s comparable to other investment product categories. They can fund a GWB annuity with stocks, bonds, money market funds, alternative investments, or a combination. Asset allocations can be changed and investment principal is guaranteed. Typically, there is also a provision for a guaranteed annual step up in the value of the account, generally about 5%. Taxes are deferred until distribution.
One variable annuity that guarantees 5% annual income for life on the invested amount (guaranteed income base) accommodates virtually any class of asset or asset mix. The guaranteed income base increases by 5% compounded annually regardless of investment performance provided distributions are not taken for the first 10 years. If the account performs better than the guaranteed rate, the guaranteed base is stepped up annually to match the actual account balance, even during the withdrawal phase.
Clients can rely on a guaranteed minimum income stream for life, no matter how long they live, even if their investment performance takes an unexpected hit. That assurance is one reason why variable annuities with living benefit riders can be an appropriate alternative to traditional no-load mutual funds, which offer no income guarantees, or bonds or CDs, which offer no inflation hedge. Naturally, all relevant differences between alternative investment options should be evaluated in each circumstance.

Qualified Accounts

In the past, the only time variable annuities made sense was for high tax bracket clients with maxed-out contribution plans. It was considered obscene to have a variable annuity inside a qualified account. However, when the client objective is a guaranteed income for life, these variable annuities are not only viable, they can actually be more appropriate in a qualified retirement account.
Using a variable annuity to generate income in a non-qualified account (as opposed to mutual funds or stocks) creates the potential for converting long-term capital gains treatment into ordinary income. Qualified accounts can be the most efficient and appropriate vehicle for variable annuities with guaranteed income benefits since distributions are treated as ordinary income anyway.

An Expert Change of Opinion

A decade ago, Dr. Moshe Milevsky, finance professor at York University in Toronto, Canada, and Steven Posner, then a derivatives quant with Goldman Sachs, published a widely cited research study, which concluded the typical variable annuities policyholder was being “grossly overcharged for the so-called protection and peace of mind.”
But writing in Research Magazine in January 2007, Milevsky does an about-face on variable annuities in light of the new guaranteed benefit riders, saying “Regardless of what you want to call these increasingly heterogeneous products, it seems the relative value pendulum has swung in the opposite direction….the annuity has finally returned to its roots; it is providing longevity insurance.”
In fact, Milevsky suggests that some insurance companies may not be charging enough for their annuities, adding, “the same mathematical models that told us a decade ago that basic death benefit guarantees were overpriced are now telling us that many living benefits are underpriced.” That’s quite a reversal of opinion by an expert on the subject.
Whatever combination of investment vehicles is chosen for retirement portfolios, uncertainty prevails as to whether they will generate enough of an income stream to last the client’s lifetime. You can debate the merits of one asset allocation strategy against another, but what I have found is that the most important issue for retirees is to have their income stream guaranteed for as long as they live.

Hazards

As advisors, we readily recognize the complexity inherent in variable annuities. They have costs and provisions that may recommend alternative choices for some retirees. Fees often run 1% to 1½% higher than no-load mutual funds. Over time, these fees can represent a substantial amount. The question is whether variable annuities are worth the perceived higher cost.
I think most advisors would agree that a retirement portfolio of mutual funds averaging 11% annual return is doing pretty well. Over time, it will inevitably experience losing years. As sub-accounts inside a variable annuities, the same investments would likely provide only 9% or 9½% average annual return because of the variable annuities insurance cost. The retiree would receive a guaranteed income stream for life. Whether the benefit overcomes the diminished portfolio performance is an issue to assess on an individual basis.
The best variable annuity for a particular client is not always apparent. If one variable annuity pays 7% guaranteed annual income and another pays 5%, clients would logically gravitate to the higher rate. An important consideration that’s often overlooked is whether the contract treats distributions on a pro rata (PR) or dollar for dollar (DD) basis.
Variable annuities with DD withdrawal treatment usually offer lower guaranteed income rates because the guaranteed income base cannot deteriorate, even if the actual account balance is depleted due to withdrawals and an extended down market. This presumes the client does not take excess distributions.
Variable annuities with PR treatment typically offer higher income rates but are subject to having their guaranteed account balance decline in value if investment performance lags. If that happens, clients may be forced to choose between reducing annual withdrawals or annuitizing the balance before it dwindles further. Either option may be an unappealing. What good does a higher rate do if clients must annuitize to get it?
Another consideration is excess distributions. Depending on how the insurer treats them, they can defeat the purpose of the variable annuities by eroding the guaranteed income base and the guaranteed income itself. Worse, the client continues to pay a premium, which could be as much as an additional point or more, for a guarantee benefit that is no longer in force. In this case, the client would have been better off funding the portfolio outside of a variable annuity.
Since guarantees are based on the claims-paying ability of the issuing insurer, diligence in choosing a product sponsor is paramount. Also, withdrawals prior to age 59½ may be subject to a 10% IRS penalty, surrender charges may apply, and withdrawals taxed at their current ordinary income rate. Obviously, a long-term focus must be the foundation for any variable annuities strategy.

Responsibility to Clients

Clients must be educated beyond the obligatory admonition to “review the product prospectus.” As advisors, we must be certain they have a solid grasp of the nuances of the variable annuity product under consideration.
As advisors, we have the option of accepting an upfront commission or an ongoing service fee from product sponsors. Taking the commission for selling a variable annuity reduces the incentive to monitor our clients’ progress to make sure they don’t inadvertently abuse or invalidate any variable annuities provisions, such as excess distributions.
I believe our industry would gain respect and credibility by eliminating upfront commissions. It would force advisors to rely on trailing income, promote better service, and help clients avoid errors or compromising their investment objectives.

A Balanced Focus

For decades, financial advisors focused on optimizing investment returns to generate adequate retirement income. But, investing is the vehicle, not the objective. The objective is replacing earned income with guaranteed income for life.
Studies show that the optimal investment mix to last an expected lifetime of 25 years is 80/20 equities to fixed income, assuming a 5% annual withdrawal rate. But, the odds notwithstanding, the chance of running out of money is always present. Also present is the chance that poor investment performance will render the calculations meaningless. It can be difficult getting retirees to accept the optimal mix if the potential for volatility scares them. Retirees may choose an asset mix they perceive as safer, but in so doing, they create a higher risk that they will outlive their money.
A singular advantage of variable annuities with guaranteed income benefits is they allow retirees to choose the most appropriate asset mix even if it suggests greater volatility because their income stream is guaranteed for life, performance notwithstanding. This can make later years so much easier for retirees, not to mention their advisors. The primary goal of ensuring a lifetime income stream is assured so retirees have more flexibility and less angst in choosing investments.
It doesn’t take a catastrophic crash to cause significant injuries in an airliner or in a retirement plan. Submitting client retirement portfolios to emergency planning is one way to help plan for unforeseen contingencies. Variable annuities with guaranteed income benefits can be a valuable part of this contingency planning, provided advisors understand product complexities, and match the appropriate product and benefit rider to client requirements. Be careful to ensure the strategy is employed within a long-tern planning environment.
––––––––––
Tom Scott, CFP™, CFS, is founder and president of Scott Wealth Management, Irvine, CA. He is a registered principal with and offers securities through Linsco/Private Ledger. Tom can be reached at thomas.scott@lpl.com or www.tomlpl.com.

The Basics
A variable annuity is a contract between you and an insurance company, under which the insurer agrees to make periodic payments to you, beginning immediately or at some future date. The value of your investment as a variable annuity owner will vary depending on the performance of the investment options you choose.
The investment options for a variable annuity are typically mutual funds that invest in stocks, bonds, money market instruments, or some combination of the three. Although variable annuities are typically invested in mutual funds, variable annuities differ from mutual funds in several important ways:
First, variable annuities let you receive periodic payments for the rest of your life. This feature offers protection against the possibility that, after you retire, you will outlive your assets. Second, variable annuities have a death benefit. Third, variable annuities are tax-deferred. In general, the benefits of tax deferral will outweigh the costs of a variable annuity only if you hold it as a long-term investment to meet retirement and other long-range goals.