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Activating An Annuity’s Income

BEN MATTLIN
September 01, 2019

Financial Advisor

Activating An Annuity’s Income

They come in many varieties, with innumerable options and add-ons. But whatever the flavor, annuities are broadly considered a good option for maintaining retirement income.

“The retirement income challenge is real and growing—and annuities are one of the only sources of guaranteed income that clients can’t outlive,” says Craig Hawley, head of Nationwide Advisory Solutions in Louisville, Ky. 

In essence, annuities are contracts that clients make with an insurance carrier. How the funds are invested and how disbursements are made may vary. But the promise of a payout is guaranteed. For many clients, the only question is when. What are the consequences of turning on the income spigot at one particular time over another?

 

No One-Size-Fits-All Answer

The answer, insists Hawley, “has to be part of a strategic plan.” That’s because what’s best for any client depends on a multitude of variables. What is the client’s income need? What other sources of income does the client have? How is the client’s health—and life expectancy?

Just as every client is unique, so is every annuity. “An annuity’s income features are generally designed to be employed at age 65,” notes David Lau, founder and CEO of Louisville, Ky.-based DPL Financial Partners, an insurance and annuities consultant primarily to registered investment advisors.

 

The Argument For Waiting

But it may be better for the client to wait until he or she is beyond 65 to take the income, says Lau. Typically, he says, it is “not beneficial to wait unless the product has deferral credits. Deferral credits can increase the payout amount in certain annuities, which may make delaying taking income advantageous.”

For some annuities, payout amounts increase when the recipient “ages out of one age band and into a new one,” explains Woodland Hills, Calif.-based Bryan Pinsky, senior vice president of individual retirement pricing and product development at AIG, a leading annuity provider. “Payments for other annuities will grow over time—either by a guaranteed rate or by market- or index-based performance—and then may get locked in after a fixed number of years.”

Annuities with a guaranteed lifetime-income rider, for instance, “often provide an income interest credit,” adds Steve Brubaker, wealth management advisor at Exit & Retirement Strategies in Denver. “The longer you wait, the higher your income will be. However, with the unknown factor of life expectancy, you’ll never know how long you’ll be receiving that income.”

Advisors, he says, must help clients “walk a fine line between maximizing their income per year and maximizing the income in the product.”

 

And The Case For Not Waiting

Nevertheless, there can be some benefit to taking income sooner rather than later. “An argument can be made to turn on the income as soon as possible,” says Peter Longo, regional insured solutions director at Philadelphia-based Janney Montgomery Scott, “typically after age 59 and a half, to avoid the 10% federal excise tax penalty for early withdrawals.”

Longo’s reasoning is clear. “The insurance company does not pay out of its pocket until the client has depleted all of his or her own money from the annuity policy,” he says. “Therefore, the longer one lives, and the sooner the contract value goes to zero, the more money will be received from the insurance company’s pocket.”

Like life insurance policies, annuities have payout rates typically tied to life-expectancy tables, he says. Clients who live beyond their life expectancy “benefit more from the lifetime income options that annuities provide,” says Longo.

 

Social Security

For most retirees, though, the primary income conundrum concerns Social Security. Many are tempted to start collecting Social Security at age 62, but waiting to age 70 can greatly increase payouts. “That’s where an annuity, such as a single premium immediate annuity (SPIA), can be the right solution,” says Hawley at Nationwide, referring to the simple annuity contract in which clients pay an up-front premium for the promise of a guaranteed lifetime income thereafter.

Such an arrangement, he says, can help retirees manage the income gap while they’re waiting for Social Security benefits. “Using an immediate annuity for income now and postponing Social Security until later allows clients to maximize their income benefits and generate significantly more guaranteed retirement income over their lifetime,” he says.

This scenario can be trickier, however, if an annuity is part of a retirement account such as an IRA.

Retirement accounts require a minimum distribution (RMD) at age 70 and a half. If the account contains a single premium immediate annuity, say, the annuity assets are exempted from the RMD calculation. But if it’s a variable annuity, which invests in a mutual-fund-like subaccount, “the impact on RMDs depends on whether or not the VA’s income stream has been turned on,” explains Hawley. “Before the VA’s income stream is turned on, the annuity’s value is included when calculating RMDs. Once a VA starts generating income, its value will no longer be used to calculate RMDs.”

For clients who can wait even longer for retirement payments, a different annuity strategy may make the most sense. Dylan Huang, a senior vice president and head of retail annuities at New York Life in New York, suggests, “One way to defer RMDs beyond age 70 and a half is the qualified longevity annuity contract (QLAC).” 

Created in 2014, QLACs are longevity annuities that allow clients “to defer a portion of RMDs up until age 85,” he says. Specifically, they enable clients to convert up to $130,000 (as of 2018) from a 401(k) or IRA to a QLAC. “This way, you are also deferring paying taxes on money that you may not need in early retirement,” says Huang.

 

Tax Implications For Heirs

Another consideration for annuities held in retirement accounts is the effect on heirs. “Annuities do not share the advantage of a step-up in basis for heirs,” says Steve Parrish, co-director of the retirement income center at the American College of Financial Services in King of Prussia, Pa.

He explains that if an heir sells an inherited stock, say, the taxable gain is the difference between the current price and the price when inherited, not the price when the shares were originally purchased. So if it is sold right away, there is no capital gains tax at all. But this step-up in basis does not apply to annuities—unless they’re within a qualified retirement account.

“Current law allows the heir to stretch out receipt of that IRA account over the heir’s life expectancy,” says Parrish, who is based in Des Moines, Iowa. “This has the effect of pushing out taxes over a number of years.” (Note: Congress is currently considering limiting that IRA stretch to 10 years.)

Distributions, however, are taxable. “For heirs, when inheriting retirement accounts or annuities, taxes must be paid on any distributions,” says Laura Parker, an advisor at Sage Rutty & Co. in Rochester, N.Y.

It goes without saying that advisors need to know their clients’ wishes and goals. What may be less obvious is that they also should be familiar with the intricacies of the annuities their clients hold. “Advisors should be very clear about all of the pros and cons of annuities,” says Parker. “I’m always careful to point out that while the bells and whistles [such as] living benefits of an annuity can be very attractive, there is usually a high price to pay for them.”

Indeed, many VAs with a guaranteed lifetime income rider come with fees of 2% to 3.5% of their value, she cautions. “There is also a limit to how much you can take out without disrupting or reducing the income benefits,” she says. “So if you need a large lump sum of cash in a hurry, then you could be stuck with high back-end fees or severely reduced benefits.”

The sheer diversity of annuity products reflects the range of goals they’re designed to meet. “That really is the beauty of a flexible, customizable approach,” says Kelli Hueler, CEO and founder of Hueler Income Solutions, a low-cost income-annuities specialist in Minneapolis. 

 

The 5% Annuitization Rate

Ironically, only about 5% of annuity buyers ever actually annuitize—that is, convert their annuities into income payments. It’s as if the longer a client holds onto an annuity—or any other asset, for that matter—the longer he or she feels protected.

“The advantages to deferring annuitization include a growing account balance and a gradually increased payout rate whenever an investor decides to take distributions,” notes Marshall Heitzman, retirement planning and sales consultant at CUNA Mutual Group in Minneapolis. “The disadvantage, similar to saving without ever spending, is postponing enjoyment of an increased income.”

But a careful withdrawal strategy can preserve the comfortable, safe, security-blanket feeling. “There are many strategies that utilize the benefits of an annuity through a withdrawal plan that doesn’t require annuitization of the full contract balance to generate the desired guaranteed income,” says Heitzman.

To other observers, the infrequency of annuitizations may actually indicate a lack of understanding about how annuities work. “Some offices oversell these products,” posits Brubaker at Exit & Retirement Strategies. “Advisors need to provide clients with personalized education on using annuities to generate income, as it truly varies by individual.”

Though annuities aren’t for everyone, he says, “if used in the right way for the right reason, they’re worth every nickel.”