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I’m probably not what you would call an “annuity guy.” I’m not licensed to sell annuities, nor do I believe they are the magical hammer that transforms every financial planning goal into a nail. Touting “No fees!” and “Provider pays the commission!” as though the products are offered for free out of the goodness of insurers’ hearts looks like icky opacity to me.
My view is that the index participation in a fixed index annuity (FIA) is generally just a gimmicky way to offer a bond-like expected return with unnecessary stock beta. That heightens my annoyance when certain industry participants generate absurdly optimistic historical illustrations. I’m not at all certain that the rise of private equity-backed annuity providers utilizing offshore reinsurance to fund private credit lending is necessarily problematic, but I am nonetheless exasperated that due diligence on such products invokes a sentence like this one. And I will keep screaming into the wind about the need for fairly-priced, inflation-linked (or at least inflation-hedged), lifetime annuity income benefits until I die or such products manifest themselves.
That being said, I am someone who holds an unshakeable belief in the superior outcomes that arise from pairing goals-based planning practices with goals-based investing techniques. And doggone-it if annuities aren’t sometimes just the best tool for certain jobs!
Secure, lifetime income can be a powerful mechanism for immunizing (a portion of) a client’s annual budgetary cash flow need, which is typically one of the largest and most vital financial goals upon commencing retirement. I’ve written repeatedly and at length about using TIPS to craft1 a stream of inflation-protected income to cover “inflexible” budgetary expenses in retirement. But for more flexible expenses and for longevity hedging2, an annuity, via mortality pooling, can provide an attractive payout relative to what investors can build for themselves.
Benefits of cash-value annuities in an IRA
A surprising additional advantage may exist when a client with a high IRA balance wants supplemental lifetime income, especially when the annuity selected for this purpose carries a cash value (or “accumulation value”)3, as do fixed index annuities (FIAs) and variable annuities (VAs).4
Before I explain, I should say that I am even far less a tax or legal professional than I am an annuity guy. This article is provided for educational purposes only and includes no individualized recommendations. Anyone considering an annuity purchase and/or a given tax strategy should seek out advice from the relevant professionals. However, some remarkable general observations can be made about the treatment of cash-value annuities for tax purposes, contrary to the common notion that annuities in already tax-deferred IRAs carry no tax advantages.
Most notably: Because retirees are allowed to pool all their IRA assets for the purpose of calculating and satisfying their required minimum distributions (RMDs), a high income-to-cash-value ratio can empower annuities to cover not just their own RMDs but a substantial portion of the RMDs for other IRA assets as well.
I should note that the recently finalized IRS RMD rule, most notable for its clarifications around the treatment of beneficiary IRAs, extended this benefit to cash-value annuities’ conceptually simpler brethren, immediate annuities, by allowing retirees to use the actuarial fair value of an income annuity for RMD calculations.
Previously, such annuities were treated as covering their own RMDs only. But the tax treatment for cash-value annuities can be even more attractive, and the new rule makes the RMD treatment of such annuities potentially even better than it was previously, as I’ll describe below.
Important: Buy an income-focused annuity
FIAs and VAs are (sometimes obnoxiously) complex beasts5, and in taking advantage of this RMD opportunity, it’s important to consider annuity products with generous income riders. Some FIA/VA products are available with income terms that are competitive with SPIA rates, especially when accounting for the fact that the cash value becomes a death benefit in the event of untimely demise. And if the retiree plans to wait a while before taking income, FIAs can compare surprisingly favorably to deferred income annuities (DIAs):6
- My research indicates that if clients plan to defer income for 1-10 years, it is often possible to find FIAs with a minimum lifetime income guarantee exceeding that of a DIA.7
- If a retiree is already of RMD age or will be prior to the desired commencement of annuity income, then a DIA is not allowed in an IRA anyway! (Aside from a qualified longevity annuity contract, or QLAC, which is a great tool but not really relevant to this discussion.)
However, some cash-value annuity products have relatively anemic income benefits and emphasize other bells and whistles. If a given retiree could get, say, 7% of the up-front premium every year from a SPIA, picking a VA/FIA that offers a 3% guaranteed lifetime withdrawal benefit (GLWB)8 would be a great way to miss out on the entire point of this article.
How it all works
Let’s do some math! Suppose we have a 73-year-old client with a 73-year-old spouse who has $1 million in an IRA. Further suppose that our goals-based analysis of the clients’ retirement needs calls for the creation of $30,000/year of lifetime supplemental income.9 Our research lands on a FIA that offers a guaranteed lifetime withdrawal benefit (GLWB) with a 7.8% joint life payout.
(By the way, I’m not going to recommend or even name specific products in this article. But I will mention that this analysis comes from the perspective of a fee-only RIA recommending commission-free annuities, and my numbers reasonably reflect present-day, real-life annuity illustrations.)
The client can thus achieve the target income by purchasing this annuity with $384,815 of IRA assets. The remaining $615,385 can be invested in a stock/bond portfolio, potentially tilted towards stocks, since the annuity’s coverage of the income need inoculates the portfolio from sequence-of-returns risk.
At age 73, RMDs on the IRA are commencing as well. However, the age-73 RMD requirement is only 3.77%.10 Less than half of the GLWB payout is required to cover the annuity’s own RMD. The remainder of the income benefit reduces the need to distribute from remaining investment assets by $15,486. Instead of 3.77% ($23,222), only about 1.26% ($7,736) of the investment assets will need to be distributed and taxed as ordinary income. Alternatively, for the same total tax, a $15,486 Roth conversion could be performed.
By making a few assumptions that affect the precise figures but not the overall point, we can generate an illustration that estimates the evolution of the cash/accumulation value in the annuity. Because the income benefit is larger than any interest accruals, the cash value declines each year, finally hitting zero after 14 years.
This sounds like a bad thing, but since the income benefit was the point of the annuity purchase, the cash value is of minimal relevance to this client anyway. And because the cash value declines faster than the RMD requirement grows, the dollar amount of the “RMD shield” produced by the GLWB gets larger every year.
This effect is most powerful in the last few years with a positive cash value. At age 87, the $30,000 GLWB payout is higher than the annuity’s initial cash value. Yet the RMD requirement, still calculated off the cash value, is only $1,767, leaving a $28,233 “RMD shield” to reduce the RMD burden on the IRA investment assets!
Applying a simplistic 6%/year growth rate11 (the choice is unimportant) to the investment assets, we can illustrate the effect of this RMD shield on remaining IRA investment assets.
Even as the investments grow and the required distribution percentage increases, the annuity’s payout above its own RMD continues to reduce the residual RMD requirement from the portfolio by more than 40% every year through age 87.
What about the clients’ 88th year, which in this example is the first year where the annuity’s cash value has gone to $0?12 This is where the new SPIA treatment becomes relevant, as RMD rules revert to immediate/single-premium treatment. In the past, this meant the annuity would suddenly revert to covering only its own RMD by rule. However, under the new RMD rule, the actuarial value of a qualified annuity’s lifetime income guarantee, at prior year end, is used to determine the RMD instead.
Let’s suppose both clients are still alive at age 88, and let’s assume that both interest rates and actuarial tables resemble their current values. In that case, the actuarial value might be about 10 times the annual payout. This ~$300,000 actuarial value would have a 7.23% RMD requirement of ~$21,900, leaving about $8,100 for an RMD shield and reducing the portfolio’s RMD burden by about 11% of its ~$64,000 total.
This typifies the general result that the “RMD shield” effect is often stronger with high-income cash-value annuities. But the existence of any RMD shield from an immediate annuity is a pleasant improvement over past treatment.
Final word
Please note that I am not directly comparing modeled outcomes to the option of leaving the entire asset base in a traditional investment portfolio. Nor am I comparing it to an example where inflation-protected income is generated from a TIPS ladder instead – which, notably, can manifest a similar RMD shield effect when ladder assets are distributed as cash flow.13
The decision of whether to generate lifetime income with an annuity should be made on its own merits, e.g., as part of a holistic, goals-based investing process. In those cases where annuitized income is deemed beneficial, though, this article has illustrated why the purchase of a qualified annuity from IRA assets may be more attractive than you might expect.
In his roles as chief investment officer for Round Table Investment Strategies and portfolio manager for Torren Management, Nathan Dutzmann is responsible for applying financial science and investment research to the process of constructing portfolios tailored to the individual needs and goals of clients nationwide. Nathan was previously an investment strategist with Dimensional Fund Advisors and a partner and chief investment officer with Aspen Partners. He is also a member of the investment industry advisory council for The American College of Financial Services. He holds an MBA from Harvard Business School and a master’s degree in international political economy and a bachelor’s degree in mathematical and computer sciences from the Colorado School of Mines.
1 Yes, that’s 11 articles focused on or heavily involving TIPS. But don’t worry, that’s a curated list, and we have more if you need them!
2 But have I mentioned my frustration that the longevity hedge in an annuity is not protected against (especially unexpectedly high) inflation?
3 Not to be confused with the cash surrender value, which may be lower due to surrender charges. But this distinction is effectively moot when an annuity is purchased for the purpose of generating lifetime income.
4 Also RILAs. Other products may fit this category now or in the future.
5 “Also RILAs” applies here too. Maybe more so.
6 Confusing to the point of comedy, a FIA or VA on which you take an income benefit right away is still called a “deferred annuity” in the industry lingo. Whereas a DIA (a deferred income annuity) is still considered a type of immediate annuity! In fact, DIA can also stand for “deferred immediate annuity”! No, really.
7 I should point out that this is very odd theoretically, since a DIA has no other purpose than generating income, whereas a FIA theoretically involves paying for other benefits than just income. The primary explanation for this oddity is a behavioral anomaly, which is that the insurer knows that many folks will purchase FIAs and then forget to turn on the income rider at all – or even surrender the contract – which creates a boon for the insurer, a portion of which can be passed back to the annuitants who do remember to turn on the benefit. There is also a scarier prospect, the theory of which I can conjure but the unknowable magnitude of which goes back to my previously noted frustration with assessing the true degree of default risk: I.e., if insurers (via complex captive reinsurance methods, GAAP vs. SAP accounting, etc.) can take more risk with the assets that effectively underlie a FIA policy, they could generate a higher income benefit in exchange for elevated default risk. Is this an accurate picture, though? I have no idea! And neither do you, and quite possibly neither does anyone else. And anyone who might know may also be conflicted. That is frustrating!
8 By stating “the up-front premium,” I’m eliding questions of “3% of what?” Rollup rates, etc. complicate the math, but my basic point is simple: The strategy outlined in this article works best with cash-value annuities offering generous lifetime income benefits.
9 Nominal income. (Screaming into the wind.) Notably, though, the generosity of the nominal amounts available from certain annuity products does give pause when compared to extant inflation-linked options (e.g., a TIPS ladder or inflation-linked LifeX funds, which also invest in TIPS) – though TIPS are also free of credit risk. My rule of thumb is that once “inflexible” (real) spending needs are covered by a combination of Social Security and TIPS, nominal annuity income becomes a potentially quite attractive alternative or complement to a traditional, total-return-based dynamic withdrawal strategy.
10 I used Charles Schwab’s RMD calculator for this article.
11 Even in this setting, where it doesn’t make any difference to the point of my article, I cringe at applying a “risk-free” growth rate higher than the actual risk-free rate.
12 This $0 accumulation value after 15 years illustrates the semi-figmental nature of the so-called cash value of an annuity, as it now appears lifetime income is being magically generated from a $0-valued policy. The fact that the IRS allows the policyholder to use the cash value – i.e., an increasingly nonsensically low assessment of the true value of the policy – in calculating RMDs is a major source of the generous RMD shield investigated in this article.
13 Albeit a less generous shield, per the prior endnote, since the actuarial and RMD accounting values for a TIPS ladder always match.
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Advisor Perspectives welcomes guest contributions. The views presented here do not necessarily represent those of Advisor Perspectives.
