Annuities? Helping Your Clients See the Long-Term Benefits

Read any industry publication and you’ll see that the buzz is about retirement income solutions. The choices include variable annuities (VAs) offering a range of different living benefits, target date mutual funds, and payout mutual funds, all designed to generate income during retirement years.

But with all the hype, one statistic has been overlooked: The median baby boomer is 54 years old, and the youngest boomer is in their mid-40’s. With ten to twenty more years until retirement, accumulation is still a big issue for more than half of the 76 million boomers, as well as the younger generations following them. In this era of do-it-yourself planning and a failing retirement safety net, experts agree that most Americans need to save more. But many consumers have a big objection to annuities—simply stated, they’re hesitant to tie up today’s savings for tomorrow’s income. So how can you help them overcome this block to see the benefits of annuities?

To maximize long-term savings, few things beat the power of tax-deferral. When you stockpile your investments for years or decades—compounding growth without stripping away 15 to 39 percent in taxes each year during the accumulation period—you could have substantially more by the time you reach your retirement.

A study, co-authored by University of Chicago professor, Ira Weiss, Ph.D., and Jefferson National, set out to prove this point. You may be surprised to learn that tax deferral can quickly outperform a taxable investment. It may surprise you even more to learn how little time it can take for a tax-deferred account to break even with, and then outperform, a taxable account. The key is using a low-cost, no-load tax-advantaged investing solution.

By the numbers: It doesn’t take long for tax deferral to work

How does the accumulation power of the tax-deferred, flat-fee VA stack up against a taxable account?

  • In just four years, the typical mutual fund investor with a conservative portfolio will likely generate more income from a flat-fee VA than a taxable account.
  • After 10 years, investors with a moderate risk profile will break even and then outperform a taxable account.
  • After 14 years, aggressive investors will break even and earn more.
  • Investors using an active management strategy almost always improve performance within the first year.
  • Higher after-tax returns are achieved when tax-inefficient assets are held in a flat-fee VA and tax-efficient assets are invested in a taxable vehicle.
  • This research goes on to show that tax-deferral can help increase returns an average of 100 bps—without increasing risk. Meanwhile, the asset-based fees of a traditional variable annuity, averaging 1.35 percent annually, can virtually eviscerate the accumulation benefits of tax deferral, and quickly erode the performance potential of a portfolio.

    In addition to the flat-fee advantage, this new breed of VA works harder than the traditional VA by offering a broad selection of investment options—virtually a tax-advantaged investing solution with 9 times more funds than the typical VA. By eliminating commissions, surrender fees, and complex insurance features, flat-fee VAs create value dramatically faster than traditional VAs.

    More time on your side with the flat-fee VA

    The intuition is simple: The longer a portfolio can benefit from tax-free compounding, the more it can accumulate versus a taxable account. For the typical moderate investor with just 10 years to save, the gains in a flat-fee VA can add up.

    But what about the tax implications at withdrawal? With the flat-fee VA, all gains withdrawn are taxed as ordinary income. With the taxable account, these withdrawals will benefit from lower tax rates—generally, a mix of dividend income rates, long-term capital gains rates (e.g., from share sales), and ordinary income rates (e.g., from interest income). However, the benefit of tax-free compounding over 10, 20, and 30 years can be so great that it outweighs the cost of higher taxation upon withdrawal.

    And as you can see, in addition to time horizon, there is another factor at work: the tax efficiency of the asset class.

    Different types of assets have different tax characteristics, or tax-efficiencies, and may benefit from tax-deferral to different degrees. Interest-income-producing assets in the conservative portfolio—such as long-term bonds—benefit from tax deferral to a higher degree than assets that benefit from unrealized capital gains—such as large cap equities.

    Benefits for the active manager

    In a taxable account, trading creates a taxable event that can generate further drag on returns. Trading frequency can span a wide range, including passive indexed fund holding, rebalancing with no other turnover, rebalancing with some additional turnover, and active management. Regardless, in a flat-fee VA, investors can turn over their portfolios without generating any tax consequences.

    The case for active managers is especially compelling. Active managers frequently move in and out of positions, trying to benefit from short-term market moves. While this has the potential to capture alpha, the inefficiencies of paying ordinary income tax on short-term gains may offer little upside. But trading inside a flat-fee VA permits unlimited trading while deferring all ordinary income taxes on gains to a future date, which is almost always more advantageous.

    Sweet spot: high-net-worth clients

    High-net-worth clients can easily max out the low contribution limits of their 401(k)s and IRAs. They’re also more likely to receive lump sums during their accumulation years, such as an inheritance, bonus, or asset sale. If forced to save for the long term in a taxable vehicle, many of these investors could leave a considerable amount of money on the table.

    A flat-fee VA, however, provides an excellent alternative to maximize tax-deferred savings, allowing lifetime contribution limits of $10 million or more, with no restrictions on contributions in a given year. Right off the bat, larger accounts can benefit with the flat-fee VA. Also, break-even periods decline as contributions increase—a big win for high-net-worth investors with longer time horizons.

    The big takeaway

    Although the market’s focus on retirement income is important, the reality is that retirement income is largely a function of accumulation. If an investor wants to generate more retirement income, they need to accumulate more. Fortunately, most boomers, and the generations that follow, have many years of accumulation ahead of them. These investors should be maximizing accumulation, and tax-deferral can help. Tax-deferral can supercharge accumulation, translating into increased income at retirement.

    While traditional tax-deferred vehicles, such as 401(k)s and IRAs, are adequate for many Americans, higher-net-worth individuals (and even many middle-class households) can easily max out their contributions. Many could benefit from more tax deferral. So what is the solution? New flat-fee VAs, used as a low-cost, no-load tax-advantaged investing solution, can be an important tool in any retirement portfolio, especially for assets that are currently tax-inefficient.

    With ten to twenty years or more until their retirement, more than half of all boomers have an opportunity to make a decision that will affect the financial security of their retirement.

    So, instead of paying for income benefits today, which won’t be used for years or decades, boomers could benefit from your counsel to keep the focus on watching costs and accumulating more, to generate more retirement income when they need it.