From The New York Times. Read the original article here.
By PAUL SULLIVAN
Published: May 10, 2013
LIFE insurance and annuities are supposed to accomplish straightforward goals: life insurance provides for your family if you die unexpectedly and annuities guarantee a steady stream of income in retirement. But right now, both are being promoted for their tax benefits.
Thomas Pauloski, national managing director at Bernstein Global Wealth Management, says it can be difficult to know what fees will apply to a policy.
Money put into these products grows on a tax-deferred basis just as it does in retirement accounts. In the case of annuities, the money is eventually taxed as ordinary income when it is taken out. With permanent life insurance, the death benefit goes to the beneficiaries free of income tax, but if it is a permanent policy, as opposed to a term policy, the owner of the policy could also borrow against its cash value and never pay income tax on it. (The insurance company charges interest on the borrowed money, though, and that loan reduces the value of the death benefit if it is not paid back.)
And while insurance companies are using the tax issue as a selling point, that is by no means the full picture. I have written recent columns on how this year’s tax increases have influenced behavior around estate planning and investments. As in those two cases, the decision to buy various life insurance policies or annuities can be unduly influenced by the tax advantages inherent in insurance. Many policies carry high upfront and management fees, have limited investment options and penalize people for withdrawing their money within a few years of buying the policy or annuity.
With these downsides, insurance companies are regularly looking for reasons to sell their products beyond the death benefits of insurance and the steady income stream of annuities.
“Oftentimes these products are sold based on the moment in time,” said Richard Coppa, managing director of Wealth Health, a financial advisory firm. “A couple of years ago, they were sold on guaranteed returns of 6 or 7 percent because people were so fearful. Today, it’s uncertainty about taxes because many of the favorable tax treatments out there are subject to negotiation.”
He said there were certainly people who were afraid of running out of money in retirement who could benefit from an annuity. He pointed to people with $250,000 to $500,000 in assets who could calculate how much money on top of Social Security they would need and buy an annuity that would cover that.
“I think you really need to run the numbers and understand the charges and compare those to an investment portfolio where you’ll get an expected rate of return,” he said.
Given the lure of tax-deferred savings, how should people weigh that against the risks and downsides of insurance and annuities?
Thomas Pauloski, national managing director at Bernstein Global Wealth Management and a former insurance company executive, said people could go wrong when they did not fully consider how long they wanted to keep their money in an insurance policy and how much the company was charging them in fees.
If they are going to pull out the money out in a few years, insurance makes little sense since fees will cancel out any gains. What’s trickier is knowing what those fees are going to be, even over the long haul.
Mr. Pauloski said among permanent insurance options — as opposed to term insurance, which has no cash value — only so-called private placement life insurance policies were clear about their fees, but that was because these policies were custom-made for someone paying a premium often in excess of $1 million. With more common forms of permanent insurance, like universal and whole life, finding the fees becomes more difficult, he said, because of how they get embedded in the policies.
More confusing still is how the returns on the cash value of the policy are presented, since they can mask the high fees. “Any insurance illustration is going to have a lot of assumptions built into it,” he said. “It assumes, for one, that today’s pretax dividend is going to continue forever. That is simply not going to happen.”
When presented with a proposal for a client, he said he often went back to the insurance company and asked it to redo the calculations with lower, more realistic assumptions. Even that, he said, is not perfect because it assumes a consistency that is unlikely.
With annuities, the fees start to pile up when people elect additional features, like a guaranteed, minimum payout. Those fees reduce the return and the value of the tax deferral.
Since the annuity company paid a commission to the broker who sold the annuity, there are also so-called surrender fees for taking your money out in the first five to 10 years of the annuity.
“My premise is annuities are second only to hedge funds in their ability to separate people from their money,” said Richard Del Monte, president of Del Monte Group, an investment adviser. “Generally speaking, they’re awful but there are specific situations.”
Among Mr. Del Monte’s exceptions are older annuities that have high guarantees and favorable terms for adding more money; another is the offerings of stripped-down, low-cost deferred annuities from newer annuity companies. These aim to preserve the benefit of the tax deferral through low management costs and no extras.
Mitchell Caplan, chief executive of Jefferson National, one of those low-cost annuity providers, conducted a study on the value of tax deferral to make the case for his company’s offerings. It analyzed what assets were best held in tax-deferred accounts and at what point fees reached a level that negated the benefit of that deferral.
Mr. Caplan said the study found that annuity management fees over 1 percent began to reduce the value of owning assets in a tax-deferred account. (Jefferson National charges a flat annual fee of $240, which, based on its average account size, is about 0.10 percent. It also does not pay commissions to advisers who sell them.)
Joseph W. Spada, senior principal at Summit Financial Resources and a longtime skeptic of annuities, said lower-cost annuities allowed his wealthy clients to own high-tax investments like hedge funds without worrying about their tax consequences. He recommended them, he said, when clients had fully funded all of their other tax-deferred vehicles, like retirement accounts.
For people in high-tax states like New York, this strategy could make particular sense, Mr. Pauloski said. If the return on a hedge fund were 10 percent, an investor in a high-tax state might give up half of that to taxes. If an annuity owned the same fund, though, the return could be closer to 9 percent if the annuity fees were low enough.
Mr. Spada said he put $1.5 million of his own money into a Jefferson National annuity because he could not put any more into his pension plan and wanted to maintain his allocation to high-tax tactical investments in a tax-deferred way.
But he said he also had a client with a net worth of $100 million who put $7 million into one of his annuities. “It’s not so he can get more retirement income that he’s never going to need,” Mr. Spada said. “I told him to let it grow tax-free and leave it to charity or put it into a stretch account and leave it to his kids.”
Mr. Spada said that fears over access to the money because of penalties and taxes were overblown when it came to low-fee annuities. If people were able to leave the money in an annuity for 10 years, they would have about the same amount after paying penalties and taxes as they would if the money been in taxable accounts.
Most people do not have millions of dollars to put into these products. They have to consider annuities and insurance in a more basic way.
“What I’m trying to do is to get people to stop thinking about life insurance as a plug-in for something else and start thinking about it as a risk-adjusted investment,” Mr. Pauloski said “The one risk we really can’t do anything about with our portfolios is an early death and, in the case of annuities, it’s outliving our assets. Use those insurance products to provide a better risk-adjusted return over the lifetime of their portfolio.”