By Lori Parker, Esq.

Annuities, like dogs, come in a multitude of breeds. Both pit bulls and poodles can be loyal and trusted companions — if matched with the right person. Finding the right match is likewise key when it comes to annuities.

Whether an annuity can be a faithful source of financial support in the client’s retirement depends upon a variety of factors, including the client’s age, income, and net worth; the amount invested; the length of the payment period; and the type of annuity. The right annuity, used in the right way for the right client, can offer unparalleled benefits. Some annuities, however, such as those with hidden, hefty commissions or that are unsuitable for the client’s needs, are “dogs” in the most pejorative sense.

At the core of all annuities is the idea of trading an asset — usually money, but sometimes business interests or other assets — in exchange for a stream of income paid over the course of time. Because of their ability to deliver a stream of income, annuities are popular retirement planning tools.

Types of Annuities
Buying into an annuity based only on the asset-for-income trade-off is like adopting a dog knowing only that it has four legs. For some clients, the asset-for-income swap is the extent of their knowledge about annuities. To lead our clients toward educated investment decisions, we need to go beneath that broad definition. There, the family of investments called “annuities” divides into a series of mutually exclusive options.

Fixed versus variable: A fixed annuity provides a guaranteed amount in each periodic payment. On the other hand, the payouts from a variable annuity are wholly or partially based on the performance of the annuity’s underlying investments.

Deferred versus immediate: Deferred annuities invest funds — typically deposited in increments over the course of time — for the long term. Immediate annuities, by comparison, have a single premium, and must make payouts, in substantially equal increments, starting no less than one year from the date of purchase.

Commercial versus private: While commercial annuities are investments in insurance products, private annuities are typically contracts under which one family member agrees to make periodic payments to another. Private annuities can be used for succession planning in a family business. This technique allows the younger generation to buy the business over the course of time, using periodic payments. Those periodic payments, in turn, provide a stream of retirement income for the elder generation. Both commercial and private annuities can also be used for Medicaid planning purposes, as discussed below.

Qualified versus nonqualified: “Qualified” and “nonqualified” might sound like comments on the fiscal soundness of a given annuity, but that’s not the case. Rather, the distinction is one relating to the taxability of deposits and withdrawals.

Qualified annuities are part of tax-advantaged retirement plans, such as 401(k) and 403(b) plans and IRA accounts. Like those accounts, they are:

  • Funded with pre-tax dollars;
  • Subject to taxation as ordinary income on the full amount of future installment payouts;• Subject to contribution limits, early withdrawal penalties, and minimum required distributions starting at age 701/2;
  • Available only to individuals who have earned income in the year of deposit.
  • If it does not fit within the “qualified” rubric, an annuity is nonqualified. Nonqualified annuities are those offered to individuals by insurers and investment companies, or privately.

Nonqualified annuities are:

  • Funded with after-tax dollars; therefore, the periodic payments are taxed only on the income generated on the investment;
  • Generally subject to early withdrawal penalties; but not to mandatory withdrawals at age 701/2 (no mandatory withdrawal age under federal rules; some states, however, require payouts at 701/2);
  • Not restricted to those with earned income in the year of deposit;
  • Unlimited as to the amount that can be deposited annually (but some sellers of annuities limit the amount that a client may invest each year).

The Artisanal Annuity: Handcrafted for the Client’s Needs
After placement within their “either/or” species, annuities can be mixed and matched to create the right breed for the client’s needs. For example, an annuity can be simultaneously fixed, immediate, commercially available, and nonqualified.

The remainder of this article focuses on nonqualified, commercially available annuities and how they can benefit two distinct types of client in their iterations as

  1. fixed or variable and
  2. deferred or immediate.

Goal: Maximize retirement assets for a client still in the workforce.

Annuity type: Deferred; either fixed or variable based on client preference.

Nonqualified deferred annuities provide an excellent growth opportunity for clients who are planning for retirement, but who intend to remain in the workforce for the next several years. By making large deposits, a working client can substantially build their retirement nest egg, and only the growth component of that nest egg will be taxed at withdrawal. High-earning clients — those whose incomes are well above their expenses — are best positioned to take advantage of the benefits associated with nonqualified deferred annuities.

Unlimited deposits can turbocharge the catch-up efforts of those who have been less-than-diligent savers during their earlier working years. Likewise, unlimited deposits can boost retirement savings for those whose income has previously been directed toward other expenses, such as payment of children’s college tuition or investment in building a now-profitable small business.

As with any investment, the balance of the client’s risk tolerance against their desire for growth will determine whether the annuity should be fixed or variable.

Goal: Supplement limited retirement benefits for a retired client

Annuity type: Immediate; fixed

A second group of clients — those who are already retired, and whose expenses threaten to outpace their income — can also benefit from investing in an annuity. For this purpose, a single premium immediate annuity (SPIA) wins the blue ribbon.

Retired clients who have limited income from Social Security and/or other retirement benefits may feel a financial pinch each month, and need more monthly income to feel secure in retirement. These clients likely have assets, but relatively modest ones. A portion of such assets, deposited into a SPIA, can yield a stream of income that will cushion the client’s financial situation.

Clients who are transitioning from home ownership to renting in a senior community are ideal candidates for investment in a SPIA. Their home is likely mortgage-free, and will yield a healthy lump sum when sold. Investing the home’s equity in a SPIA can provide clients with additional income — which they may need to cover their rental costs — for the remainder of their life. For these clients, the need for safety and stability dictates that the annuity be fixed.

Downsizing is sometimes a reflection of the client’s declining physical and/or mental status. For clients at this juncture, investment in a SPIA can serve a dual purpose. First, it transforms a lump sum into a stream of income, as described above. Second, the client can liquidate non-exempt assets1 and invest the proceeds in a SPIA, which transforms the asset from non-exempt to exempt.

For Medicaid purposes, a SPIA must be irrevocable, actuarially sound, and payable to the local Medicaid agency as a remainder beneficiary. Investment in such a SPIA can aid the client in transforming non-exempt assets into a Medicaid-permissible stream of income.

Another situation well suited to a SPIA is where the client is retired, is over 591/2 but under age 701/2, and wants to defer Social Security and tax-deferred distributions until the last possible moment. Such a client can take a limited distribution from their tax-deferred account to buy a SPIA. The SPIA, properly structured, will generate sufficient income to cover the client’s needs until they reach their Social Security and required distribution milestones. The client has thus maximized their Social Security benefit and their opportunity for growth in the tax-deferred account.

Caveats and Questions
Even the best-behaved dog has the potential to deliver a nasty bite, and even the most advantageous of annuities come with a sheaf of foreboding, small-print paperwork. If not fully read and understood, such details can result in unpleasant financial surprises in the future. Regardless of their financial position, clients who invest in annuities should ask questions and heed a few important caveats.

1. Can the annuity be passed along to a beneficiary?
Many annuities simply end when the client dies, so the annuity payor benefits if the client dies early, and loses if the client has a long life. In contrast, some annuities offer a joint and survivor benefit, which allows the client to name a beneficiary (usually a spouse), who will receive payouts when the client dies. Designating a beneficiary may diminish the monthly benefit to the client, but the diminution is usually miniscule when measured against the benefit of assured income for the surviving spouse. Some annuities factor a fixed death benefit into their payout structures. Before committing substantial monies to an annuity, clients should understand whether it can be inherited, and if so, under what circumstances.

2. Will the investment in the annuity significantly deplete the client’s available resources?
Balancing the need for immediate income with keeping sufficient resources available for unexpected events is a particularly salient concern when investing in a SPIA. Investment of a larger amount will likely yield a higher monthly payout. But if the investment strips the client of resources to cover emergencies, it hasn’t relieved the client’s financial distress — only changed its appearance. Even high-income clients can be caught short of assets if they deposit too aggressively in annuities. These clients can correct the income shortfall by slowing their contributions or diminishing their amount.

3. How does this annuity compare with other investments having similar levels of risk?
An annuity’s performance is intertwined with its costs, such as sales commissions, asset management fees, and early withdrawal penalties. High costs can erode outstanding performance, depriving the client’s growth potential within the investment.

Annuities typically offer generous sales commissions, generally 10 percent of the amount invested. For variable annuities, annual management fees can total three percent. To be competitive with low- or no-fee investments, a cost-laden annuity will likely expose the client to greater-than-expected risk. A salesperson who focuses the client’s attention on the payout amount and deflects cost-related questions may be protecting their commission more than serving the client’s interests. A salesperson who turns tail and runs when asked for detailed, clear cost information is a salesperson who belongs in the doghouse.

To avoid the hidden charges, clients can buy annuities directly from investment firms or benefit funds. The absence of an intermediary/salesperson doesn’t erase the need for due diligence. The client should still investigate fees and other costs, and compare the projected return with that of other investments.

Annuity Whisperers
As elder law attorneys, we have intellectual and intuitive resources that others may lack, and by using those aptitudes, we can become “annuity whisperers.” We can keep annuity sales pitches on a short leash, calm clients’ worries that they may not have enough for a comfortable retirement; and guide clients through unfamiliar investment territory. Our objectivity, the fiduciary nature of our relationships with clients, and our ability to evaluate both short- and long-term implications of investment choices all spotlight us as a breed apart from commission-based advisors. As we match clients with the annuity that is “best-in-show” for their needs, we add value to our representation and distinguish our practices from the rest of the pack.

Citation
1 The Medicaid program permits long-term care recipients to retain specific assets — referred to as “exempt” assets. Non-exempt assets, if not preserved as part of a Medicaid plan, must be applied in full toward the cost of the client’s care. Examples include vacation homes and non-retirement investment accounts.

This article appears courtesy of National Association of Elder Law Attorneys (NAELA)

Lori Parker, Esq., Rochester, N.Y., is co-chair of the NAELA Medicare, Medi­caid, and Health Care Advocacy Section