The new 401k/IRA modification rules that have passed the House of Representatives and are now being taken up by the Senate will provide a number of improvements and simplification for high net worth taxpayers, while also taking away the ability to “stretch out” distributions from an IRA that would go to a child or other non-spouse over the non-spouse beneficiary’s lifetime, and instead allow for there to be non-required distributions for a full ten years from the death of the IRA owner, or ten years after a minor beneficiary has reached age 18 when applicable.
Other improvements will be that the age when distributions need to begin coming out of an individually owned IRA will be 72 instead of 70½, small employers will be able to reduce the cost of establishing and maintaining a 401k plan by sharing the plan with other employers, and an exception to the 10% excise tax on distributions before the IRA owner reaches the age of 59½ upon the birth or adoption of a child is now provided. In addition, the Act also provides that 529 Education Savings Accounts may be used to cover expenses associated with qualified apprenticeships, home schooling, and up to $10,000 of qualified student loan repayments, in addition to costs associated with private elementary, secondary and other religious-based schooling.
But the most negative financial damage that will be done to U.S. senior citizens and middle aged IRA owners comes under a provision that seems clearly intended to benefit the insurance industry by explicitly allowing, and in fact encouraging, the sale of “lifetime benefit” annuity contracts that can be held under an IRA for the ostensible purpose of assuring the IRA owner that he or she will receive minimum distributions for life.
I have strong opinions about these complicated annuity contracts because of the significant financial damage that I have seen foisted upon elderly, and not so elderly, non-sophisticated and sophisticated clients, as further described below and on YouTube from a talk I gave at the Notre Dame Estate and Tax Institute that can be viewed by clicking here. In an article titled “9 Reasons You Need To Avoid Variable Annuities,” Eve Kaplan asserts that the only individuals who actually do like variable annuities – the sales agents who earn commission on them.
The House Bill does contain language which will require certain suitability and cost standards to be met, and to assure that the life insurance carriers that write the lifetime benefit contracts have reasonable financial strength and are registered with State oversight authorities.
By the same token, the new statute provides relief from fiduciary liability for IRA custodians and retirement plan trustees who purchase these contracts, as long as they have verified that certain standards have been met, which will, without doubt, allow large compensation amounts to be paid from the monies paid into the investment contracts and held under the contracts to go to sales personnel and the life insurance companies, although hopefully these payments will not be as high as we typically see in non-IRA “guaranteed income” annuity products, as further described below.
One Senator that might have difficulty agreeing with the loosening of this fiduciary duty is Senator Elizabeth Warren. In 2015, Warren wrote letters to 15 different insurance company executives expressing her concerns that the current incentive structure creates a situation where “annuity dealers often have significant financial conflicts of interest that could prevent them from offering their clients the best individual options.” For a copy the letter, click here.
In 2017, Warren backed a Department of Labor proposal, The Conflict of Interest Rule, that prohibited “financial firms from compensating their advisers in ways that encourage and reward them for making recommendations that are not in their clients’ best interest,” and expanded the investment advice fiduciary definition to apply to all financial professionals who provide retirement planning advice.
Expanding this rule obligated financial professionals of all kinds to act in the best interest of their client, rather than just finding suitable investments, and eliminated many commission (kickback) structures that currently existed within the industry.
The new fiduciary rule that was to be phased in, was shelved in 2017 via executive order and officially vacated by the U.S. Fifth Circuit of Appeals in 2018. Currently, the Department of Labor is working with the SEC to resurrect the rule. For more on this, click here. For more information on Senator Warren’s efforts in this arena, you can visit her website by clicking here.
The present standard of fiduciary duty, as stated in another article outlining the dangers of equity-indexed annuities found here, allows annuity companies and agents to play by their own rules. Disclosures of an advisor who sells life insurance and annuity contracts is very low compared to the normal fiduciary standards that apply to trust companies and “fiduciary” investment advisors who agree, or are required by their mode of operation, to do what is in the best interests of their client. See Barry Flagg’s article “Life insurance ‘advice’ in an era of fake news” here. In the article, Flagg stresses that “advisers who have clients’ best interests at heart, and who want to stay out of harm’s way, should insist upon the disclosure of actual internal policy costs and performance” of life insurance policies that are marketed toward their clients.
While at first blush this appears to be a well reasoned and appropriate mechanism, in reality, the abuse of investors by insurance carriers and sales organizations that now takes place outside of the IRA arena will now find its way into it. The huge and, up until now, mostly undamaged IRA investment assets, which constitute the largest or only investment vehicle for millions of Americans, will be under threat.
The problem that we most commonly see is that a senior citizen is informed that a specially designed insurance-based annuity contract will give the senior citizen the better of the following each year: (1) a portion of the rate of return of one or more selected market indexes, or (2) a minimum rate of return to guarantee annual growth of their investment. In addition, the investor is told that they will have the ability to convert the account into an income stream where the annuity/IRA owner will receive income for life based upon a favorable rate of return guarantee that they are permitted to believe will be at the rate that applies under Section (2) above, but it is not.
What the annuity owner is not told is that the investment advisor may receive a commission between 8% to 10%, and that the stock market based element of the contract (Section (1) above) may be charged between 3% and 4%, or more, a year, or will be capped, and that the investor will not be credited for dividends that the indexes would normally pay, in order to give the insurance carrier money to pay the sales commission and advertising and other expenses of the carrier.
The investor is also commonly not informed that the surrender charge for the product can exceed 10% in the early years, and that surrender charges can apply for ten years or longer, so that the investor is basically “stuck” with the contract, even when they later realize that it is not what they thought they were buying. The investor is also not normally told that the insurance carrier reserves the right to change the percentages of charges and the rates of return that are “guaranteed,” to make sure that the insurance company is profitable, even if this causes the rates of return that are touted to be much lower than advertised.
The biggest sales deception will typically be that the investor is told that they will receive no less than a certain percentage rate of return, such as 5% a year, and that when they convert the contract to a lifetime income stream, this will continue. This is the Section (2) above.
In reality, what happens is that the company tracks two separate amounts. The first amount is the actual investment return of the contract, which is subject to the annual charges that can be 3% to 4% a year, or more.
The second calculation (Section (2)) is what we call the “phantom account,” which is what the account would be worth based upon the greater of the investment return described above (the actual investment return minus 3% or 4% or more), or the minimum rate of return (which may be advertised as 5%.).
The investor will receive periodic statements showing the actual cash value of the policy based upon the first calculation, and the “retirement value” or “phantom value” as the second number.
Unfortunately, neither balance will receive the “guaranteed rate of return” once the investor converts the contract to a lifetime income stream.
Instead, this is typically based upon a 2% or 3% rate of return, which is well below what a reasonably allocated investment portfolio would be expected to return.
As a result of the above, the IRA owner loses 8% to 10% of the value of their hard earned investments under the IRA upon purchasing the contract, and 3% to 4% or more per year on average, from what a typical low cost reasonably allocated stock and bond based portfolio would earn.
Of course, there are exceptions to any rule. For example, Vanguard and Fidelity offer low cost, no sales charge and no surrender charge annuity contracts, and have well versed phone assistants that can be called to explain how these contracts can work, and how the contracts of their competitors work.
Also, the above is a simplified explanation of where we normally see the harm done. There are other annuity contracts called deferred fixed annuities that can be purchased to simply pay a minimum fixed annual payment for life. Vanguard and AARP are two common sources of these and the purchaser gets the exact amounts they have paid for.
There are also lower commission and commission free versions of these contracts that are available to many investor advisors, but are rarely used because the vast majority of investment advisors who are compensated based upon a percentage of investments or hourly fee do not recommend them.
One hybrid form of contract is called an “equity index” annuity and works very much like what is described above, although the sales literature would lead you to believe otherwise.
Many readers have – or know someone who has – one of these expensive contracts held outside of an IRA, and may wish to consult with an expert. Any annuity contract can be exchanged or surrendered up to 10% per year, without incurring any surrender charges, by simply cashing in that portion of the contract, or exchanging it for a less expensive contract, which will allow for deferral of income tax if the contract being surrendered has taxable income built up inside it.
For future updates on the revamped IRA distribution rules, please stay posted!