Setting the record straight: Using annuities in qualified plans
By Jason Ryan
Annuities are a funding method for a full range of qualified retirement programs. However, this concept has always prompted much debate. Some critics argue that government regulations and ethical guidelines weigh against placing annuities into qualified plans. Others contend that, since both annuities and qualified plans offer income tax-deferral, putting an annuity in a qualified plan is redundant and inappropriate. Finally, some advisors claim that variable annuities are more costly than other qualified plan investments and that these higher costs could reduce overall performance in the long run. Most of the unfavorable views concerning annuities in qualified plans are based on a lack of understanding regarding the features, benefits and expenses of the underlying annuity. It's time to set the record straight.
For many years, fixed and variable annuities have been used extensively as funding vehicles for qualified retirement programs. This is due to the favorable design of these products, which provides not only professional investment management of retirement assets, but also incorporates important insurance protections of assets and a future income stream.
In 1952, the first variable annuity in America was designed and developed for a qualified retirement program for educational employees. It was called the College Retirement Equity Fund (CREF). In fact, the variable annuity (VA) was available only as an investment within a tax-qualified plan until 1960, when the first publicly available VA outside a qualified plan was developed and brought to market.
The history of variable annuities in qualified plans is strong and clear, with the basis formed by Congress through statutory provisions in the Internal Revenue Code of 1986.
- Section 401 - Qualified Pensions, Profit Sharing and Stock Bonus Plans
- Section 401(f) - Annuity Contract Shall be Treated as Qualified Trust
- Section 403(a) - Qualified Annuity Plan
- Section 403(b) - Annuity Purchased by Section 501(c)(3) Organization or Public School
- Section 408(b) - Individual Retirement Annuity
- Section 457 - Plans Established for State and Local Government Employees, funded with Annuities
The double-tax-deferral question
Some argue that an annuity inside a qualified plan replicates the retirement plan's built-in income tax-deferral feature and that such a transaction is unnecessary because the purchaser receives no benefit from this "double tax deferral." The redundancy argument would have more validity if annuities offered income tax deferral as their sole benefit and if insurance carriers charged a fee for this same singular benefit. However, this is not the case.
The tax-deferred status afforded to annuity owners is not a benefit created by the issuing insurance companies; it's the result of a congressional mandate. Decades ago, Congress declared that annuities may grow on an income tax-deferred basis. No insurance company issuing annuities has ever charged a fee for the income tax deferral provided by these products.
Since the "double tax deferral" redundancy costs nothing, and in many cases the annuity provides additional benefits, it seems unreasonable to claim that the buyer of an annuity within a qualified plan has somehow been misled.
The cost question
The simple fact that two products sell for different prices does not necessarily mean that the less expensive product is a better buy. The more expensive product may have benefits or values the less expensive product lacks. The additional expense incurred in the typical VA, as compared to other investment vehicles, is due to the added protections an annuity contract provides. The insurance company takes on the responsibilities of mortality and expense risks under the VA contract, thereby removing these risks from the individual. For example, a variable annuity may provide guarantees that reduce overall investment risks and provide guaranteed income -- a feature not found in other products. A fee is charged to pay the insurance company's expenses for providing these guarantees.
While 401(k) plans do not charge commissions or trading costs, they may have associated costs that are not fully disclosed or paid for by the plan sponsor. Employers routinely shift these expenses to their employees and the costs can add up. Studies indicate that qualified plan participants may be paying additional administration, trustee and bookkeeping fees of up to 250 basis points a year to maintain their 401(k)s1. If a retired 401(k) participant pays as little as 100 basis points for maintaining his 401(k), adding the 140 basis point cost of owning mutual funds in the account results in a total cost that exceeds that of the variable annuity by 20 basis points.
The true cost of owning a variable annuity in a qualified plan may be less than owning similar investments in these plans. Even if the cost is slightly higher, the benefits provided by the annuity could outweigh the expense. Following are some of the benefits that account for the cost disparity:
Death benefit: Annuities guarantee the owner that, regardless of what happens to the value of the underlying investments held in the annuity, the beneficiaries will receive the greater of the market value of the annuity at the contract holder's death or the net value of the contributions paid into the annuity.
In recent years, variable annuity companies have improved upon their death benefit offerings. Several issuers pay a death benefit equal to the highest account value reached by the annuity before the owner's death. Other issuers allow an annuity owner to purchase a death benefit that is guaranteed to increase in value each year at a set percentage rate and some issuers will even combine these options and pay the beneficiary the greater of the two death benefit amounts. These benefits ensure that the owner's beneficiaries receive, at minimum, proceeds that exceed net contributions made by the annuity owner.
Income tax reduction: As a rule, qualified plans are subject to ordinary income taxes in the hands of beneficiaries following the death of the plan owner. One of the major benefits of having a qualified plan held in an annuity is the opportunity to reduce or eliminate the income tax burden facing beneficiaries who inherit qualified plans. Of all the investment vehicles available to qualified plan owners, only the annuity provides an earnings-enhancement rider that reduces or eliminates the income tax burden on inherited qualified plans. In order to help beneficiaries of the annuity pay income taxes associated with the inherited asset, annuities offering this benefit charge a fee to provide additional cash at the owner's death.
Principal protection: Many annuities offer a guarantee against loss of invested principal. Principal protection benefits are referred to as living benefits because the annuitant receives the benefits during his or her lifetime. In order to obtain these benefits, the owner must hold the annuity for a specified period of time, typically between seven and 10 years. This seldom poses a problem for most individuals who are funding a qualified plan.
Guaranteed income for life and guaranteed rates of growth: Annuities provide the guarantee of income payments for the life of an individual or the joint lives of two individuals -- no matter how long they live. As more individuals fear that they will run out of money during their retirement years due to increases in longevity, this guarantee of lifetime income payments is becoming increasingly important. Several carriers also currently guarantee that the amount invested in their annuity will grow by a specified rate, usually between 4 percent and 7 percent. When elected, this guaranteed rate of growth benefit is usually paid out as lifetime income. As with other guarantees, the investor may need to hold the annuity for a specified period of time and annuitization may be required in some cases. Most annuity companies also charge an annual fee from an annuity's account value for this benefit.
Since 1952, annuities have been used extensively in the full range of qualified retirement programs. From pension and profit-sharing plans, including employee 401(k) programs, to Sect. 403(b), 457 and individual retirement accounts and annuities (Sect. 408 IRAs), VAs have been used to provide a valuable combination of investment management, insurance protection of assets and a guaranteed income stream. The protections provided by the variable annuity are important and available for a fee and billions of dollars are invested in variable annuities within qualified plans for that very reason.
1United States Government Accountability Office (GAO) Study-- "Changes Needed to Provide 401(k) Plan Participants and the Department of Labor Better Information on Fees," 2007
The opinions and forecasts expressed are those of Jason Ryan as of January 29, 2009, any may actually not come to pass. This information is subject to change at any time, based on market and other conditions and should not be construed as a recommendation.
An annuity is a long-term, tax-deferred investment designed for retirement. Earnings are taxable as ordinary income when distributed and, if withdrawn before age 59½, may be subject to a 10% federal tax penalty. Variable annuities involve investment risks and may lose value
Jackson and its affiliates do not provide legal, tax, or estate-planning advice. For questions about a specific situation, please consult a qualified advisor.
Annuities and life insurance are issued by Jackson National Life Insurance Company (Home Office: Lansing, Michigan) and in New York, annuities are issued by Jackson National Life Insurance Company of New York (Home Office: Purchase, New York). Variable products are distributed by Jackson National Life Distributors LLC. May not be available in all states and state variations may apply. These products have limitations and restrictions. Contact the Company for more information.
As required by the IRS, you are advised that any discussion of tax issues in this material is not intended or written to be used, and cannot be used, (a) to avoid penalties imposed under the Internal Revenue Code or b) to promote, market or recommend to another party any transaction or matter addressed herein.
*For further information, or to contact this author, please leave a comment and your e-mail address in the forum below.