Annuities For High Net Worth Individuals
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Table of Contents
Introduction
In this article, we will discuss annuities for high net worth individuals.
Do you wish to learn one of the richest people’s best-kept secrets? They use annuities for a variety of purposes, such as estate planning, tax reductions, and more.
Even though annuities have been around since the Roman Empire, many investors still find them confusing due to the variety of options and fees involved.
Along with other possible advantages, these financial products may offer a stream of retirement income that is guaranteed.
Even though the advantages of annuities are less significant for high-net-worth individuals who can rely on substantial assets, some annuities can still be beneficial to have as part of a comprehensive retirement plan.
What Is An Annuity?
An annuity is a flexible contract offered by an insurance provider that transforms the premiums paid by investors into a stream of fixed, guaranteed income.
An annuity contract, more precisely, is a contract between you and the insurance provider that governs your financial future.
Your longevity risk—the risk that you will outlive your savings—is transferred to the insurance provider by this contract. You exchange this by paying the premiums specified in the contract.
How Do Annuities Work?
A lump-sum premium paid for an annuity is transformed into an income stream that one cannot outlive. For many retirees, meeting daily needs requires more than investment income and Social Security.
In the case of immediate annuities, lifetime payments are guaranteed by the insurance company and start within a month of purchase, so there is no accumulation phase required. Annuities are designed to provide this income through a process of accumulation and annuitization.
The insurance company receives a premium when you purchase a deferred annuity, in essence. The terms of your contract will determine how much of the initial investment will increase tax-deferred during the accumulation phase, which can last anywhere between ten and thirty years.
You will start receiving regular payments as soon as the annuitization, or distribution, phase starts — once again, in accordance with the terms of your contract.
Contracts for annuities shift to the insurance company all of the risk associated with a down market. You, the annuity owner, are therefore shielded from both market risk and longevity risk, or the risk of outliving your money.
To balance the risk, insurance companies charge fees for contract riders, investment management, and other administrative services.
The majority of annuity contracts also have surrender periods, during which the contract holder is not permitted to withdraw funds from the annuity without paying a surrender fee.
In addition, indexed annuities are frequently subject to caps, spreads, and participation rates from insurance companies, all of which can lower your return.
Why Use Annuities?
People spend years making sacrifices and saving money to increase their net worth, but they may discover that their net worth is falling as a result of market downturns.
Therefore, high net worth people are looking for a source of income and the security of their principal.
The saying “an investor is more concerned with the return of his principal than the return on his principal” couldn’t be more true today than it has ever been.
The vocabulary of the high net worth individual includes terms like investment diversification, investment media, principal safety, and limited market exposure.
Annuities and insurance have always been important pillars of individual financial planning.
Because the asset does not receive preferential tax treatment when it is taxed, annuities have received criticism.
3 Types of Annuities For High Net Worth Individuals
1. Longevity Annuity
Most retirees express concern about outliving their savings as one of their top worries. A longevity annuity, also known as an advanced life deferred or delayed annuity, can offer some comfort.
Before the annuitant (the person who purchases the annuity) reaches a certain age, usually around 80, payouts do not start. The annuity then provides a lifetime of guaranteed income.
The drawback? The beneficiaries of an annuitant receive nothing if they pass away before reaching the minimum payout age.
2. Hybrid Long-Term Care Annuity
Annuities that combine long-term care riders and fixed annuities are known as hybrid annuities. Due to rising long-term care insurance premiums and the fact that a lot of insurers are no longer willing to sell conventional long-term care policies, these annuities have grown in popularity in recent years.
The hybrid long-term care annuity uses a standard deferred fixed annuity with a fixed interest rate as its base, but it also finances a long-term care rider with some of the interest earnings.
Beneficiaries gain from this type of annuity as well as annuitants, who can always take their money back at a later time. The annuity may be bequeathed, avoiding probate, if the annuitant decides not to use the long-term care rider.
3. Charitable Gift Annuity
With charitable gift annuities, investors can simultaneously generate income, lower their tax burden, and make a donation to a good cause.
The annuitant makes a donation to a single charity, usually for no more than $5,000, which is then placed in a reserve account and invested to begin the annuity.
The annuitant will receive a set monthly payment for the rest of their lives, based on their age at the time of the donation. The remainder of the donation goes to the charity after the annuitant passes away.
In addition to the income generated by charitable gift annuities, you might also be eligible for a tax deduction at the time of the initial donation.
The estimated amount the charity will receive following the completion of all annuity payments will serve as the basis for the tax deduction. A portion of the payments you receive might also be tax-free depending on how long you expect to live.
Benefits include flexibility in gift types such as cash, personal property, and securities, an immediate tax deduction for the donation, and a guaranteed lifetime income stream, some of which may be tax-free.
The disadvantage is that donations cannot be refunded after they have been made. Additionally, there will be no inflation adjustment made to the charitable gift annuity’s income stream.
The Pros and Cons of Annuities for High Net Worth Individuals
The Pros of Annuities For High Net Worth Individuals
Annuities do have some benefits for investors who are considering retirement, despite the criticisms.
Guaranteed Income
No matter how long the annuity owner lives, the insurance company is still liable for providing the promised income. That pledge, however, is only as reliable as the insurer making it.
This is just one reason why investors ought to only work with insurers that have received favourable financial strength ratings from the main independent rating organizations.
Money-Management Assistance
For investors who would prefer to delegate that work to professional, variable annuities may offer a variety of features like recurring portfolio rebalancing.
Customizable Features
The needs of the buyer can frequently be met by modifying annuity contracts. For instance, a death benefit clause can guarantee that, in the event of the owner’s passing, the heirs of the annuity will receive at least some compensation.
No matter how well the performance of the mutual funds in a variable annuity, a payout is guaranteed by a guaranteed minimum income benefit rider.
A surviving spouse’s income can be continued through a joint and survivor annuity. However, each of these features carries a supplementary cost.
The Cons of Annuities For High Net Worth Individuals
High Commissions
The commissions earned for selling annuities are almost always higher than those earned for selling mutual funds. Let’s say a shareholder transfers a 401(k) balance of $500,000 into an IRA.
A commission of about 2% might be earned by the financial advisor if the money is invested in mutual funds. The advisor may receive a commission of 6% to 8% or even more if it is placed in an annuity that holds the same or comparable mutual funds.
As a result, an advisor who advised a $500,000 rollover into mutual funds would receive a commission of no more than $10,000, whereas an advisor who advised the same rollover into an annuity would likely receive a commission of between $25,000 and $35,000. Naturally, a lot of advisors will suggest an annuity to their clients.
Surrender Charges
The insurer may charge hefty surrender fees if an annuity owner needs to withdraw money from the annuity before a set amount of time has passed (typically six to eight years, but occasionally longer).
Tax Penalties
A 10% early withdrawal penalty may also be applied to any money withdrawn if the annuity owner is under the age of 5912.
High Fees
Most annuities don’t charge sales commissions up front. Even though they may appear to be no-load investments, they still incur a lot of fees and expenses.
Annual maintenance and operating fees are imposed by annuity contracts, and these fees are frequently much higher than those incurred by comparable mutual funds.
It has started to change a little bit recently, and some insurers are now providing annuities with relatively low annual expense ratios. Investors should always read the small print before signing, though.
IRAs Will Have No Additional Tax Benefits
Tax sheltering already exists for annuities. Until the owner starts to receive income, the investment earnings increase tax-free. The owner is also qualified for a tax deduction for the money they put into the annuity each year if it qualifies as one.
However, if a traditional IRA or 401(k) is invested in traditional mutual funds, it will typically have the same tax advantages at a much lower cost.
Therefore, it is redundant and wasteful to place an annuity in an IRA, as investors may be advised to do by some eager salespeople.
Why High Net Worth Individuals Buy Annuities
- High Net Worth individuals frequently take their pensions in one lump sum and do not have enough income for retirement, necessitating the need for a source of funds for fixed expenses.
- The conversion of annuities to Single Premium Immediate Annuities (SPIA) today or the use of an income rider in the future can both guarantee income.
- Guaranteed income with the potential to earn interest is offered by fixed and fixed index annuities.
- It is possible to maximize benefits for parents and kids while ensuring safety by spreading out IRA distributions over several generations using a fixed annuity.
- Family members may gain when a life insurance policy is funded with the proceeds of an existing fixed annuity, as well as the possibility of receiving retirement income.
- Fixed and fixed index annuities ought to be a part of each person’s financial plan because they might offer the security and comfort in money that High Net Worth individuals seek when they retire.
- Until the owner decides to take the income, fixed and fixed index annuities defer taxes on the income.
- When compared to CDs and treasury bonds, fixed and fixed index annuities may offer a higher rate of return while also helping to protect capital, maintaining access to funds (subject to a surrender fee).
- Split annuity strategies can take the place of CDs by substituting and enhancing the income through an SPIA while the remaining principal grows back to the original amount in a fixed deferred annuity.
- Long-term annuity holders now have the option to use their annuities to pay for a life insurance policy using the High Net Worth client’s estate thanks to annuity wealth transfer.
- The risk to the principal in fixed and fixed index annuities is minimal.
- High Net Worth individuals frequently take their pensions in one lump sum and do not have enough income for retirement, necessitating the need for a source of funds for fixed expenses.
- The conversion of annuities to Single Premium Immediate Annuities (SPIA) today or the use of an income rider in the future can both guarantee income.
What Are The Benefits Of Annuities For High Net Worth Individuals?
High-net-worth investors are becoming more aware of the special advantages of annuities.
Despite the fact that these insurance-sold investment products are best known as instruments for converting savings into lifetime income, high-net-worth investors are becoming more interested in them as a way to maximize after-tax gains, leave more to heirs, counteract the effects of inflation, and stabilize portfolios during a period of extreme volatility.
1. Increased Tax Deferral
An investment-only variable annuity (IOVA) offers the chance for additional tax-deferred investing after you have maximized contributions to an IRA and 401(k). Gains accumulate tax-deferred, and when they are withdrawn, they are taxed at current income levels.
There is a 10% penalty for withdrawals made before the age of 59 and a half. Investors are responsible for paying contract fees as well as costs associated with underlying investments.
There are some IOVAs that have annual tax-deferral limits, but they are less expensive than the 0.5% to 1% that 401(k)s charge annually.
In the case of its Investment Edge Variable Annuity, Equitable eliminated its annual fee this year. Investor Advantage Variable Annuity from Lincoln National Life has a 0.10% annual fee.
2. Safety From Creditors And Predators
Annuities are completely shielded from creditors and baseless lawsuits in some states, including Florida and Texas.
For the 1%, who are frequently preyed upon by greedy businesses and people, this can mean a lot. The only product that makes such safety guarantees is a fixed annuity, where a person chooses a guaranteed payout of their money.
3. Reduce Trust Taxes
The top 37% income tax rate becomes effective on income of $13,451 and is notoriously onerous when it comes to tax rates on trust assets.
Trust assets can grow tax-deferred—completely shielded from the burdensome tax system of the trust—at a low annual cost by being invested in low-cost passive funds within a cheap IOVA.
4. Lower Risk
Guaranteed transfer-of-risk products include annuities. Many people take pleasure in using at least some investment strategies that protect their assets.
You won’t be making much extra money with annuities because they don’t technically fall under the category of investments, but you also won’t be losing any either. Simply put, it’s a good way to save for retirement.
Annuities are seen as a way to eliminate risk by high net worth individuals because they typically already have enough risk in their lives from their jobs and other investments.
5. Stretch Inherited Assets
The Secure Act of 2019 did away with a popular legacy planning technique used by wealthy families: the so-called stretch IRA.
The assets in an inherited IRA could continue to grow tax-deferred over the course of the heirs’ lifetimes. The new law requires heirs to liquidate assets within ten years, drastically reducing their potential value.
It is still possible to spread out inherited nonqualified annuities over the lifetimes of the heirs. For large inheritances, this could be a huge win.
6. Lower Taxes
True or false, people with high net worth pay much higher tax rates than the general population. Annuities, however, can support you in that.
1%-ers can reduce their tax exposure by deferring taxes and increasing their exclusion ratios on annuity payouts.
Fixed deferred annuities have short three-year surrender periods and can guarantee an annual percentage yield. The best annuity strategy for your specific circumstance should be discussed with a financial expert.
7. More Ballast and Development
When it comes to safety and yield, fixed annuities are tough to beat. They perform better than other safe investments and protect the principal.
Aspida Life Insurance Company in early October offered a fixed annuity with a five-year fixed rate of 5.3% while the best five-year CD rates were around 4% and five-year Treasuries paid 4.1%.
Fixed annuities, which offer high yields on principal protection, can produce the kind of portfolio stability that is typically offered by bonds, allowing investors to take more risk in other areas of their portfolios.
The impact of inflation must be countered by maintaining a healthy stock allocation. Our use of annuities with wealthy clients is primarily done to increase their level of comfort with increased equity exposure.
8. Interest Rates Are Not A Concern
The contractual transfer-of-risk guarantee that annuities provide is much more important to high-net-worth individuals than its interest rates. Because of this, they don’t worry about trying to carefully time their annuity purchase with constantly fluctuating interest rates.
Their straightforward approach to annuity investing typically yields benefits that outweigh the question of whether they were able to secure the best interest rate.
9. More Opportunities For Estate Planning
Annuities effectively pass outside of probate even though they cannot be transferred to beneficiaries tax-free like life insurance.
As you likely already know, the process a legal court uses to settle all of your financial and legal matters after your death is known as probate. Given that it can be a drawn-out and expensive process, the fact that annuities are exempt from it is really beneficial.
Many 1%-ers incorporate annuities into their estate plans using contractually guaranteed legacy strategies. Consult a financial expert to determine if this might be the best option for you.
What Determines Annuity Rates?
Depending on the type of annuity, different rates are set for annuities. For instance, the rate of a fixed annuity is determined by the issuing insurance company. They will offer a fixed-term, typically three to ten years, rate guarantee.
For other types of annuity contracts, where the interest rate may change over the course of the contract, rate setting is more difficult. For instance, a fixed indexed annuity offers both a fixed rate and a rate based on the expansion of an equity market index. To maintain the rate within a predetermined range, the indexed rate may be set in accordance with a number of variables, such as rate caps and floors.
How Are Annuities Taxed?
Due to their potential for tax-deferred growth, annuities are frequently recommended to clients by financial professionals. Your investment grows tax-free for the duration of the contract once you buy the annuity. When the annuity matures, you won’t start paying taxes until you start receiving income payments.
Depending on the type of annuity you have, a portion of your payout may be subject to tax. If you possess a qualified annuity, income taxes will be due on the entire withdrawal sum. On the other hand, only earnings are taxed on withdrawals from non-qualified annuities.
How Do Annuities Pay Out?
There are two basic variations of annuities: immediate and deferred.
Your financial objectives will determine which option you choose. You will select an immediate annuity if you want to start getting annuity payments right away.
You can also buy a deferred annuity and explicitly state the start date in your contract if you’d like to start receiving payments at a future date.
How Do Annuities Compare To Other Fixed Income Products?
The fixed income products life insurance, certificates of deposit (CDs), and bonds are frequently contrasted with annuities. Let’s examine how annuities compare to these options.
Life Insurance vs. Annuities
Both annuities and life insurance are issued by insurance companies, but they differ significantly in several important ways.
Annuities offer lifetime income to the annuitant with the option of passing income to a beneficiary after death, whereas life insurance typically provides a death benefit following the death of the policyholder.
Both life insurance policies and annuity contracts are tax-deferred investment vehicles, and some life insurance policies have the same potential for long-term growth as annuities.
Annuity income is typically distributed as a series of payments according to a predetermined schedule when it matures. Contrarily, life insurance benefits are typically given in one lump sum to the policy’s beneficiary.
In order to purchase either the annuity contract or the life insurance policy, you must pay a premium. But for these two products, companies choose your premium in very different ways.
While life insurance premiums are based on the insured’s mortality, annuity premiums are calculated based on life expectancy.
An annuity and a life insurance policy may both be included in a sound financial strategy due to their differences. Your long-term financial objectives will determine whether either product—or both—is best for you.
CDs vs. Annuities
Both annuities and CDs are regarded as extremely secure ways to gradually increase your savings. Over a specific time period, both products offer a guaranteed rate of return. Both annuities and CDs favour preserving the principal of the investment over aggressive growth.
The two products differ from one another in some significant ways. Banks offer short-term investments called CDs, whereas insurance companies offer annuities, which are viewed as more long-term products.
While CD interest is taxed annually, taxation on an annuity contract doesn’t begin until you start taking payments.
Compared to CDs, annuities are more individualized because you can alter the contract’s terms and add extras like death benefit riders. Due to the shorter terms, CDs also frequently have lower interest rates than annuities.
How soon you anticipate needing the money you are investing as principal will determine whether you choose an annuity or a CD.
When saving for long-term objectives like retirement, annuities are preferred. But you can use CDs to save for more immediate objectives, like a down payment on a house.
Bonds vs. Annuities
In that both have a set maturity date and are bought in lump sums, bonds and annuities are similar. Bond terms cannot be modified, whereas annuity contracts can.
This is a key distinction between bonds and annuities. A bond indenture cannot be changed, but annuity contracts can have extra benefits added or terms changed before they are finalized.
The tax-deferred nature of annuities, as opposed to the taxable nature of bond income, is another benefit. Bonds typically exhibit lower long-term rates of return than annuities, and annuities typically maintain a higher carrying value. Bond values typically decrease as interest rates increase.
Both bonds and annuities can be useful tools for increasing your savings. When deciding which financial product is best for you, take into account the rewards and risks of both options and how they fit with your personal financial priorities.
Final Thoughts
Although some annuity types have a bad reputation, the ideal annuity may be the best option for an investor’s retirement needs.
An annuity purchase, however, can consume a sizeable portion of your liquid assets, and they are not without risk.
In the event that you’re considering purchasing one, it is best to consult a financial advisor and make that investment as part of a thorough retirement planning process, particularly if you have a high net worth.
Your financial advisor can assist you in thoroughly comprehending the benefits and drawbacks of a specific annuity and what, if any, alternative options might be preferable for your particular financial situation.
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Adam is an internationally recognised author on financial matters, with over 760.2 million answer views on Quora.com, a widely sold book on Amazon, and a contributor on Forbes.
