By Jennifer C. Rankin

Corporate America just can’t get a break.

In 2001, the Internet bubble collapsed and terrorists attacked. In 2002, Enron imploded and the country’s longest-running bull market ground to a halt. This year, executives are coping with a stalled economy, investor distrust, and two wars.

Financial services companies have been especially hard hit. In fact, earnings at the nation’s life and health insurers fell 52.6 percent last year to US$ 7.3 billion from US$ 15.4 billion in 2001, according to Weiss Ratings, which blames the continuing downturn in the equity markets for the industry’s profit decline.

Insurers also suffered a US$ 15.5 billion capital loss on sales of invested assets last year, right on the heels of a US$ 4.4 billion capital loss in 2001. And Weiss predicts early 2003 data will show more of the same.

The good news? The economy may be on the upswing, if second quarter numbers are any indication. According to Newsday analyst Tami Luhby, "The Standard & Poor’s 500 Index, a broad measure of the market, had its best quarter since the end of 1998, rising 14.9 percent. And the Dow Jones industrial average was up 12.4 percent and the tech-heavy Nasdaq climbed 21 percent—their best quarterly performances since 2001." In addition, the Federal Reserve has cut the interest rate to one percent, its lowest level since 1958.

How have annuities fared? According to a recent BestWire e-briefing, in a repeat of last year, fixed annuities were the main driver of the life insurance industry’s growth, while those life insurers that were focused too heavily in variable products continued to lag.

Individual and group annuities enjoyed robust growth in 2002, as both fixed and equity-indexed annuity sales rose from prior-year levels. This reflects consumer interest in products that can generate a guaranteed return while protecting principal. The miniscule returns offered in short-term bank products and negative returns generated in most equity-based products in 2002 also have fueled the significant growth in fixed annuities.

Three products in particular have fared well in a low return, low interest rate environment: single/flexible premium deferred annuities (SPDAs/FPDAs), market value adjusted annuities (MVAAs), and equity indexed annuities (EIAs).

Two experts were on hand at this year’s Annuity Conference, which LOMA co-sponsors with LIMRA and the Society of Actuaries, to discuss today’s challenging business climate and why these products are so popular. According to Donald Abbs, FSA, MAAA, CFA, director of product management at Allstate Financial, and Noel Abkemeier, FSA, MAAA, consulting actuary at Milliman USA, during the past five years:

• SPDA/FPDA sales have tripled, growing from US$ 20 billion (1998) to US$ 60 billion (2002). They’re safe, they’re simple, and they offer one- to three-year interest rate guarantees. They also comprise close to half of bank industry fixed annuity sales.

• MVAA sales have quadrupled, growing from about US$ 2.5 billion (1998) to US$ 20 billion (2002). They offer higher interest rates than comparable book value SPDAs/FPDAs. Their longer interest rate guarantees avoid the "trust me" nature of one-year SPDAs/FPDAs. A big appetite has developed for shorter than typical five+ year guarantee. The choice of a guarantee period (from one to 20 years) offers good flexibility within one contract.

• EIA sales have tripled, growing from about US$ 4 billion (1998) to US$ 12 billion (2002). They offer downside protection with upside growth potential to consumers. They pay high up-front commissions and bonuses to agents. Many leading EIA contracts illustrate very well, which gives them marketing sizzle. About half of 2002 EIA sales were in fixed accounts.

What does the future hold? According to Abbs and Abkemeier, if interest rates remain at historic lows and equity markets don’t improve, insurers may temporarily pull some products off the market. We also may see reduced commissions and lower minimum guarantees in contracts.

If the yield curve flattens, certificate of deposit (CD) sales could remove some of the attractiveness of fixed annuities in banks.

If equity markets begin to show sustained improvement, we should see variable annuity and mutual fund sales pick up, which might hurt fixed annuity sales.

The verdict’s still out on how President Bush’s tax cut will affect annuity sales.

Shifting Priorities

During the past 20 years, corporate America has become less and less willing to spend its capital to provide retirement benefits for rank-and-file employees. Simultaneously, Congress began to encourage individuals to take personal responsibility for their retirement needs by legislating various tax incentives for individual retirement accounts (IRAs), defined contribution plans—that is, 401(k) 403(b) and 457 plans—and other savings vehicles.

Americans are taking advantage of those incentives. According to the ACLI, they have accumulated significant wealth in retirement savings vehicles such as defined contribution plans (US$ 3 trillion), IRAs (US$ 2.5 trillion), and individual annuities (US$ 500 billion). But, "managing that money in retirement to make it last an entire lifetime—and that of their spouse—is the next challenge facing many Americans."

Current incentives focus on the accumulation of assets during one’s working years, says the ACLI, and provide no framework for managing those savings during retirement. One way to do just that is to annuitize accumulated assets.

An annuity is a contract that converts a lump sum of money into an income stream, a process called annuitization. Annuitization can be a sound financial strategy for retirement income. According to an ACLI consumer guide, a 65-year-old who annuitizes US$ 100,000 will receive more annual income, for a longer period of time, than one who employs alternative asset management strategies..

Annuities offer tax-deferred treatment of earnings, death benefits, and payout options that provide a guaranteed income stream.

Annuities do have drawbacks. They carry high expense loads and offer limited liquidity. And they are taxed twice at the ordinary income rate, since they are purchased with after-tax dollars and the income stream they produce is also taxed.

They are popular, however, in the middle class. Americans paid US$ 76 billion of premiums for individual non-qualified annuity contracts in 2000. Twenty-three percent of annuity-owning households have annual incomes under US$ 25,000 and 47 percent have incomes under US$ 50,000. Nevertheless, the vast majority of retirees do not annuitize their wealth, says the ACLI, and many approaching retirement do not intend to annuitize their retirement savings.

Fair Play

Many legislators want to change that and are trying to get tax parity for annuities.

Under current law, annuity payments are included in gross income except to the extent they represent a return of one’s purchase price. The portion that’s included as income is taxed at ordinary income tax rates.

The Jobs and Growth Tax Relief Reconciliation Act of 2003 (JAGTRRA)—popularly known as the Bush tax cut—left annuities out in the cold.

JAGTRAA is the third tax act Congress has enacted during the past three years. The others are the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) and the Jobs Creation and Workers Assistance Act of 2002 (JCWAA).

Congress approved JAGTRAA on May 23 and President Bush signed it into law shortly thereafter. While the President was unable to persuade Congress to eliminate the taxation of corporate dividends, JAGTRRA reduces the tax on both corporate dividends and capital gains to 15 percent. Income from interest will continue to be taxed at the ordinary income rate. Previously, dividend income was taxed at the ordinary income rate and long-term capital gains were taxed at 20 percent.

At first reading, these and other JAGTRRA provisions seem to be pretty straightforward. They’re not. According to an e-briefing Standard Life sent to its field force, JAGTRRA overlaps with the other two tax acts, causing "a confusing mishmash of rates and effective dates. In many cases, a change will be effective for a year or two and then the law will revert to a prior Act provision."

What does all this have to do with annuities? In a word, lots. Every time tax rates get cut, retirement vehicles lose a bit of their shine. Dividends and capital gains earned within an individual retirement account (IRA), a 401(k), a 403(b) or a variable annuity don’t qualify for the lower tax rate under the Bush tax cut. So when an investor begins to withdraw his money, typically at retirement, it will be taxed at the ordinary income rate, which ranges from 25 to 35 percent.

While the new laws don’t directly affect annuities, they may make variable annuities less attractive to investors. Why? Because even though a variable annuity enables an individual to defer taxes, establish a dependable income stream, and provide a death benefit to his heirs, it is no longer a tax-advantaged way to invest in the stock market. Add high expense charges, product complexity, and a bear market to the mix and you can see why investors might turn their backs on variable annuities.

MSN Money analyst Liz Pulliam Weston sums up the effect JAGTRAA may have on annuities in one word—"ouch." In her July e-briefing on how the tax cut affects retirement planning, she says, "Sales of deferred variable annuities were already suffering because of the lousy stock market and previous tax cuts. Insurers complain that the new tax rate for dividends and the further reduction in the capital gains tax rate will hurt sales even more.

"Annuities also tend to have surrender fees if you bail out early and higher expenses than comparable investments that don’t have the death benefit provided by the insurance wrapper. Those expenses, combined with the wider gap between capital gains and income tax rates, mean investors need to hold low-cost annuities for at least 20 years to break even. That’s according to calculations by the folks at TIAA-CREF, the world’s largest pension fund manager and an annuity provider."

Concerned industry executives are lobbying—thus far, without much success—for more favorable tax treatment for annuities.

SAIL Away

On June 12, U.S. Rep. Earl Pomeroy (D-N.D.) and U.S. Rep. Johnny Isakson (R-Ga.) introduced bipartisan legislation to encourage workers to annuitize their retirement savings.

"For years, the federal government has recognized its duty to assist American families in planning for a financially secure retirement," Pomeroy said in his announcement. "Saving for the long term is extremely important, but assets also must be managed properly after retirement if they are to last a lifetime. The SAIL Act will provide families with incentives to plan for a secure retirement."

H.R. 2458, the Secure Annuity Income for Life (SAIL) Act of 2003, encourages workers to secure a lifetime income stream by annuitizing some of the money they receive from their tax-qualified retirement savings plans, such as 401(k)s or IRAs. Under the SAIL Act, they would be permitted to exclude up to US$ 3,000 of annuitized retirement income payments from taxation each year. So the Act not only encourages workers to save for retirement, but also encourages them to receive a lifetime income in retirement.

More specifically, the SAIL Act would allow for 15 percent of retirement income to be excluded from tax, with the amount of retirement income eligible for the exclusion capped at US$ 20,000 per year for participants in tax qualified plans who receive all or a portion of their retirement income in the form of a lifetime annuity payout.

According to Pomeroy and Isakson, Congress has gone to great lengths to provide incentives to encourage workers to accumulate enough savings for retirement. Upon retirement, however, workers face numerous risks in managing those savings throughout their retirement years:

• An unpredictable time horizon. At age 65, life expectancy is at least 18 years, but that is only and average and not very useful in planning. In fact, a 65-year-old female has a 28 percent chance of living to age 90 and a male has a 17 percent change of living to age 90.
• Market risk. Retirees have a shorter time horizon in which to recover from market downturns. Downturns at the beginning of retirement can significantly reduce how long a retiree’s nest egg will last.
• Inflation. Income must double over a 20-year period just to stay even with average rates of inflation.
• Rep. Robert Andrews (D-N.J.) and Rep. Phil English (R-Pa.) also are original co-sponsors of the legislation.

The National Association for Variable Annuities (NAVA) was one of the first organizations to endorse the SAIL Act. "With Social Security and traditional defined benefit pension plans predicted to play a reduced role in providing retirement income in the future, and with people retiring earlier and living longer, healthier lives, it is more important than ever that they have a guaranteed source of income that they cannot outlive," said Mark Mackey, president and CEO of NAVA.

The ACLI is another strong proponent of SAIL. "A key factor behind the need for workers to secure an income for life," says ACLI President & CEO Frank Keating, "is that they will be spending more years in retirement than any previous generation of retirees. A long retirement can be wonderful. But financing a long retirement is hard. It is time for Congress to examine the second half of the retirement security equation, and the SAIL Act is a good place to start."

The SAIL Act is similar to the Pension Preservation and Savings Expansion Act of 2003 that Congressmen Portman and Cardin have introduced. According to NAVA, the amount of annuity income that could be excluded annually under the Portman Cardin bill is capped at US$ 1,000 until 2008 and US$ 2,000 thereafter. There also is a phase-out of the exclusion based on the income of the recipients of the annuity payments.

The first insurer to publicly support SAIL, MetLife sent a news release out over the wire within hours of the Act’s introduction.

"MetLife strongly supports this legislation, which will lead the way in helping Americans understand the importance of preserving assets during their retirement," said C. Robert Henrikson, president of MetLife’s U.S. Insurance and Financial Services businesses. "One of the key provisions of the Pomeroy-Isakson bill encourages individuals to preserve their retirement income by taking a guaranteed lifetime annuity payment. This will help retirees insure against one of the biggest risks they face in retirement—longevity."

The SAIL Act has stirred up other special interest groups, including the Investment Company Institute (ICI), a national trade association that represents the mutual funds industry. The ICI wants Reps. Pomeroy, Isakson, English and Andrews to expand the scope of H.R. 2458 to include non-annuitized forms of distribution—that is, periodic payments. In a letter to Reps. Pomeroy, et. al., the ICI posits that periodic payments may be more suitable for an individual, because they:

• Provide an easy-to-understand, structured form of income stream over life expectancy or another long-term period, much like that provided by an annuity, but typically at lower cost
• Provide a greater measure of flexibility to receive additional amounts to meet immediate, unexpected financial needs, such as medical emergencies or other unforeseen events that may occur during an individual’s retirement years
• Allow an investor’s assets, while they may still be substantial, to pass to one’s heirs following death
• Allow investment flexibility depending on an individual’s level of risk tolerance or other annuitized assets, such as benefits under Social Security or a defined benefit plan

In a nutshell, what’s good for the goose is good for the gander.

More Wrinkles

Introduced on April 11, 2003 by Reps. Rob Portman (R-Ohio) and Ben Cardin (D-Md.), the Pension Preservation and Savings Expansion Act of 2003 (H.R. 1776) Act would allow individuals with an income of US$ 90,000 or less to exclude up to US$ 2,000 in annual retirement plan annuity income from taxation.

H.R. 1776 builds on a previous bill sponsored by Portman and Cardin, the Comprehensive Retirement Security and Pension Reform Act, which was included in the 2001 tax relief act. It would make permanent those provisions in the law set to expire in 2010 that encourage workers to save more in tax-qualified retirement savings plans, among other things. It also adds annuities to the mix.

Just as Resource was going to press, the House Ways & Means Committee passed H.R. 1776 with a few tweaks. The legislation would exclude from taxation up to US$ 2,000 of the first five years of lifetime annuity payments from retirement savings plans. To be eligible, the retiree must choose to receive the assets in a lifetime income stream.

More specifically, the lifetime income provision of H.R. 1776 applies to tax-qualified defined contribution retirement savings plans—such as 401(k), 403(b) and 457 plans—and individual retirement accounts (IRAs). Eligibility for the incentive is phased out for joint filers with adjusted gross incomes between US$ 120,000 and US$ 150,000 per year and for individual filers with an adjusted gross income of between US$ 60,000 and US$ 75,000. The provision would take effect next year.

The ACLI was one of the first supporters of the original Portman-Cardin legislation and a lead supporter of H.R. 1776. "Our industry plays a unique role in helping people secure retirement income they cannot outlive," says ACLI President & CEO Frank Keating. "As major players in the private pension plan market, with more than US$ 1.6 trillion in retirement plan assets and approximately one-fifth of all private-sector pension and retirement plan assets in the United States, life insurers have a vital role in … boost[ing] all workers’ chances of a financially secure retirement."

Many leading insurers support the Portman-Cardin Act—including MassMutual, MetLife, Nationwide, Principal Financial Group, and TIAA-CREF—as does the ACLI.

Although JAGTRRA and SAIL have gotten the lion’s share of recent press—and a great deal of attention from annuity writers—another bill has been languishing in Congress for almost two years.

Introduced on November 16, 2001 by Reps. Phil English (R-Pa.), Nancy Johnson (R-Conn.) and Karen Thurman (D-Fla.), H.R. 3320, the Lifetime Annuity Payout (LAP) bill, now has nearly 50 bipartisan co-sponsors.

In a nutshell, LAP calls for annuity payments purchased with private savings to be taxed at the capital gains rate, rather than ordinary income tax rates, if the owner of the annuity selects a lifetime payout.

"It’s ridiculous to tax retirement savings twice as income," said Rep. English in a press release promoting the LAP bill. "Wealthy investors typically invest in stock, which is taxed at the lower capital gains rate. But investments in annuities, which are typically made by middle-income Americans, are taxed at the higher income tax rate. This is hardly fair. This legislation takes an important step by helping many people plan more effectively for the future."

Among those supporting the bill are life insurers, the ACLI, and NAVA.

According to the ACLI, which strongly endorses the bill, LAP would apply a lower tax rate to lifetime annuity payments and life insurance death benefits paid over a beneficiary’s lifetime. The portion of the annuity and insurance payment that is included in gross income would continue to be determined as under current law. However, that amount would now be taxed at the same rate the recipient would pay on any capital gains income.

In order to qualify for the reduced tax rate, the annuity or life insurance payment would have to meet the current definition of annuity payments as set forth in IRS regulations, as well as be part of a series of payments made over the life of one or more individuals. In other words, the payments would have to be guaranteed to continue for at least as long as one or more of the individuals is alive. H.R. 3320 would not apply to amounts received under qualified retirement plans or section 457(b) deferred compensation plans, which are funded with pre-tax dollars.

According to Morgan Stanley analysts, the SAIL Act falls well shy of the lifetime annuitization proposal (LAP) that many industry lobbyist groups had proposed. In a June client briefing, it said that under LAP, the annuity payout stream would be subject to capital gains tax rather than regular income tax. However, the cost of this bill in terms of lost taxation revenues is substantial.

Good Match?

While tax parity has taken center stage recently, suitability continues to be a major issue in the annuity sector, especially for variable annuities.

When is an annuity the right product to sell and when is it not suitable? Is suitability the responsibility of the issuer, the distributor or the selling broker—or is the buyer on his own? Since Resource last addressed these issues (see Back to Basics, August 2002), not much has changed.

During the stock market’s long bull run, variable annuities became extremely popular investment vehicles. As sales soared, so did the potential for sales practices abuses. "To prevent such abuse," say KPMG Insider analysts in a recent e-briefing, "securities regulators have made sales practice examination sweeps, issued member and investor publications, and taken disciplinary action against offenders. Broker-dealers are now subject to increased regulatory expectations in this area, particularly with respect to the suitability of recommendations."

Variable annuities are regulated by both securities and state insurance laws. The are considered securities under federal law, but are regulated as an insurance product under most state laws. Distributors must be registered as broker-dealers with the Securities and Exchange Commission (SEC), must join the National Association of Securities Dealers (NASD), and are subject to NASD rules.

Equity-indexed annuity (EIA) products, which combine the characteristics of both fixed and variable annuities, are in a category by themselves. "These vehicles are typically structured so that they are not registered as securities with the SEC, and the sales of EIAs are not subject to regulation by the SEC or NASD," say the KMPG Insider analysts. "Accordingly, non-registered EIAs are not subject to the customer suitability, disclosure, and sales practice requirements that apply to registered securities."

After five years of debate, the NAIC appears ready to weigh in formally on the suitability issue.

Unable to pass its original suitability proposal—the Life Insurance and Annuities Model Act—the NAIC went back to the drawing board and presented a narrower version at its spring meeting. Dubbed the Senior Protection in Annuity Transactions Model Act, the proposed regulations concentrate on sales standards for fixed and variable annuities for senior citizens.

Insurance commissioners weighed in on the new proposal at the summer NAIC meeting. At press time, they were preparing the final wording and planning to fully adopt the model by the fall NAIC meeting.

Writing for the Kansas City Star, business analyst Paul Wenske says the new guidelines:

• Establish a national standard of state suitability rules that would mirror the strong suitability standards developed by the NASD
• Emphasize that the sales of variable annuities "should be subject to heightened scrutiny by regulators"
• Encourage states to decide on their own the best way to address enforcement, whether through insurance commissioners or through securities commissioners
• Forge more cooperation between securities and insurance commissioners in enforcing the "fair-sale practices for variable annuities" regardless of which is the lead authority

"The recommendations fall short of proposing that states formally give securities commissioners dual regulation over variable annuity sales," says Wenske. "That position was supported by state securities commissioners and by the NASD. [But] insurance industry officials argued that giving state securities commissioners dual regulation authority over variable annuities would only create an extra, unnecessary layer of bureaucracy. They [believe] consumers already are protected at the state level by insurance commissioners and at the federal level by the NASD and the SEC."

The ACLI disagrees with some of the model regulation provisions and has its own proposal on the table, which it is discussing with the insurance commissioners.

These are taxing times, then, for annuity writers and distributors—both literally and figuratively. The upside? Interest rates could rise, which would help fixed annuities, or stocks could, which would help variable products. Another round of tax legislation could include annuity products. Whatever happens, we’ll keep you posted.