Annuity Contract

[Penman2006]

A TPA I do some work for wants to put an annuity contract in a new DB plan for the owner. There are other participants in the plan but I was told that the only contract would have the owners name on it but payable to the plan, therefore it's okay that the other participants do not have annuity contracts in their name.

Does this sound reasonable and more importantly is it allowable?

I don't have any experience with annuity contracts but I always thought they were a ripoff due to fees and expenses and withdrawal penalties. For example, what happens if the plan terminates in five years, what is that contract worth? How do you value it annually if you know the plan will likely shut down before the end of the contract and there are significant withdrawal penalties? Can the contract be rolled over?

I would like to hear others experiences with annuity contracts. Obviously I don't have to take the case but I don't want to overreact just because it's something different.

[Andy the Actuary]

A TPA I do some work for wants to put an annuity contract in a new DB plan for the owner. There are other participants in the plan but I was told that the only contract would have the owners name on it but payable to the plan, therefore it's okay that the other participants do not have annuity contracts in their name.

Does this sound reasonable and more importantly is it allowable?

I don't have any experience with annuity contracts but I always thought they were a ripoff due to fees and expenses and withdrawal penalties. For example, what happens if the plan terminates in five years, what is that contract worth? How do you value it annually if you know the plan will likely shut down before the end of the contract and there are significant withdrawal penalties? Can the contract be rolled over?

I would like to hear others experiences with annuity contracts. Obviously I don't have to take the case but I don't want to overreact just because it's something different.

Annuity contract sounds like an investment. Have to take care that owner cannot buy the annuity out of the plan at some low surrender value. This would be tantamount to the springing cash value LI contract. Annuities good or bad? Two actuaries, three opinions. Mine: It depends.

[david rigby]

For example, what happens if the plan terminates in five years, what is that contract worth? How do you value it annually if you know the plan will likely shut down before the end of the contract and there are significant withdrawal penalties? Can the contract be rolled over?

Reasonable questions. Why not ask the vendor? Better yet, ask multiple vendors.

[AndyH]

Two different questions (a) is it allowable and (b) is it a good idea.

(a) depends on the specifics. DB assets are not earmarked, so assets are not allocated to one person if within a plan unless part of some participating contract, so what is the point to the contract? Does it have "benefits, rights, or features" that others would not have? Probably. If so, those may need testing and the result may be a failure making (a) NO.

(b) depends on the specifics. I share your concerns and find it highly unlikely.

Earth to Ned Ryerson

[Penman2006]

I appreciate the answers so far.

Today I have been thinking about the correct way to value that asset for the annual actuarial valuation. Market value of assets is supposed to be the value that the asset would change hands between a willing buyer and a willing seller. I assume there would be some penalty for withdrawing from the contract. Since this is a small plan for an older 100% owner of a business it is safe to assume that the plan will be terminating at some point in the future. Because of that I am wondering if it is appropriate to base the annual market value of the annuity contract for valuation purposes on the value of the contract as though it was being cashed out, in other words considering the penalty for early withdrawal? After all, that is what the plan would end up with if it were terminating. If they think they can just roll that annuity contract out to the owner at plan termination then I think there would be a number of issues as pointed out by Andy H. It would be like the owner has had a separte investment account.

[Guest Ned Ryerson]

Earth to Ned Ryerson

You rang?

Of course, buying the annuity product is better than not buying it, but what you really need is life insurance and lots of it! Everyone knows life insurance is the best investment anyone can ever make. Am I right or am I right? Right? Right? Right?

[david rigby]

Well, you are consistent Ned.

[AndyH]

Earth to Ned Ryerson

You rang?

Of course, buying the annuity product is better than not buying it, but what you really need is life insurance and lots of it! Everyone knows life insurance is the best investment anyone can ever make. Am I right or am I right? Right? Right? Right?

That's because the huge commission and potentially lower returns means a huger tax deduction. Simple math, right?

[Guest Dressageho]

Annuity contracts can be good, especially in the current market. The important thing that we've been targeting where I work is making sure that the annuity contract provides for a "principal protected value." This helps AFTAP levels and other testing because the guaranteed value keeps the total value of Plan assets up even if the market tanks. You just need to work with the financial/investment person and coordinate with the Plan document to ensure that the annuity could be distributed if the Plan is terminated. Upon termination, the client (presumably the owner of the company) can be informed of the value of the annuity contract to determine whether he wants to take it as a distribution or whether the Plan should cash it out, pay any penalties, and distribute cash instead.

Also, certain types of annuities have to be based on a person's life. For that reason, it would name the owner. As long as the Plan owns the annuity contract and all payments are made to the Plan, you won't have a problem. Think of the owner as a beneficiary. Beneficiaries generally can't change the contract unless and until they own it.

[AndyH]

Annuity contracts can be good, especially in the current market. The important thing that we've been targeting where I work is making sure that the annuity contract provides for a "principal protected value." This helps AFTAP levels and other testing because the guaranteed value keeps the total value of Plan assets up even if the market tanks. You just need to work with the financial/investment person and coordinate with the Plan document to ensure that the annuity could be distributed if the Plan is terminated. Upon termination, the client (presumably the owner of the company) can be informed of the value of the annuity contract to determine whether he wants to take it as a distribution or whether the Plan should cash it out, pay any penalties, and distribute cash instead.

Also, certain types of annuities have to be based on a person's life. For that reason, it would name the owner. As long as the Plan owns the annuity contract and all payments are made to the Plan, you won't have a problem. Think of the owner as a beneficiary. Beneficiaries generally can't change the contract unless and until they own it.

You describe many of the advantages of a pillow case buried in the back yard, absent the illiquidity possibility, and of course the penalties and surrender charges. If you dig it deep enough where nobody can find it easily, it might be there a whole lifetime and be fully payable upon death as well to the designated beneficiary who gets the secret treasure map.

[Belgarath]

People who have anything good to say about annuities often don't bother to post them here, because there is a vocal portion of the subscribers who bash everything to do with them. Their prerogative, and sometimes amply justified! However, I've got broad shoulders, so I'll accept a little bashing. Annuities, like any other investment, CAN be either good or bad, depending upon the particular terms, the company issuing them, and more importantly, the specific situation and investment goals of the retirement plan. As a PORTION of an investment portfolio for a plan, they can provide a perfectly sane, reasonable investment.

Are they sometimes/often sold improperly, or have absurd and draconian surrender charges/expenses, etc? In the immortal words of that Alaskan Einstein and intellectual giantess, Sarah Palin, "you betcha." However, I've seen annuities issued on the life of a 60+ year old Trustee of a plan, as a general plan investment in a DB plan, that have ZERO load and ZERO surrender charges. Is this the norm? Probably not. (I've also seen ridiculous, 20 year surrender charges with rolling "buckets" so the charge is assessed against new money first!) But they can provide a positive, guaranteed return, with withdrawal rights at any time for liquidity, and even those with high surrender charges may offer, for example, a 10% penalty free withdrawal per year, etc...

As to "expenses" or "commissions" - the comissions must be disclosed to the purchasing fiduciary anyway, so this shouldn't be an issue - the fiduciary should be able to evaluate whether they are an appropriate investment or not. I can say that I've personally heard some plan fidiciaries recently lamenting that they wish they had bought annuities 10 years ago instead of mutual funds. And there are expenses and commissions on nearly ANY type of investment. There are "expenses" (or surrender charges for early withdrawal) on bank CD's, for example, yet you rarely hear CD's demonized.

Now, if you are talking about VARIABLE annuities, rather than fixed, I have a whole different perspective. While I'm open minded enough to listen to arguments otherwise, I'm firmly against them in a qualified plan. Buy mutual funds instead!

Bottom line - IMHO, sometimes bad, sometimes good. And the BRF feature is distinctly an issue - I think that great care must be taken with this, since they are usually issued on a HC (at least in the small plan we administer.)

And no, I don't sell anything, so whether anybody agrees or disagrees doesn't affect my paycheck! And we absolutely, categorically, refuse to offer any sort of investment advice to our clients, even though they often ask (I'm sure the rest of you find this as well.)

Let the rebuttals begin!

[AndyH]

You betcha!

Well stated. The only thing I would argue with would be the 10 year ago comment. That, like any statistic, can be twisted any which way in hindsight. I don't agree that an annuity belongs in a DB plan at any time, but that is just one personal opinion, and I certainly respect a reasoned argument to the contrary.

[Belgarath]

Agreed, but I certainly didn't present it as a statistic. Merely an observation passed on to me by those who were responsible for investing plan funds, and failed to diversify adequately or match assets to distribution timeframes. Some of those folks (and again, remember, we're talking primarily small plans where the lion's share is for benefits for owners and families) have had their assets devastated, at least in the short term, and to wait for a market recovery means they can't retire when planned. Some of those folks, with the benefit of hindsight, are wishing they invested in something more conservative.

I don't know if there is really such a thing as a valid, "basic investment theory" but if there is, it would seem to me that beyond rule 1 of diversification, it would be prudent to diversify away from risk and lean toward more conservatism as the distribution timeline shortens. A lot of small plans seem to ignore this. But then, I'm a conservative investor anyway - although since I've got a lot of years left until retirement, I must confess that once the market dropped 50%, I pulled a big chunk of my 401(k) fixed interest account out and bought into the mutual funds. I figure if they don't come back in 15 years, we're all in the toilet anyway.

But the REALLY important question is, did the Red Sox or Yankees win last night? I went to bed in the 7th, I think, and it was 1-1.

[AndyH]

Well, I happened to turn it on around the 7th inning and did not recognize a single name in the Yankee's infield or outfield, so that told me all I needed to know.

I think all the standard investing books will be re-written once we get through the current fiasco. The only question is what is the bias of the authors.