Annuities and the Law of Unintended Consequences

The Law of Unintended Consequences generally holds that human conduct will produce at least one unintended consequence over a course of time and during a series of activities or transactions.

Disclaimer:  Material is presented here for general information purposes and does not constitute legal or tax advice.  The intent of the material is to provide some insights into the issues which can arise when proper due diligence and qualified counsel may be somewhat absent during the annuity sales process. 

The law of unintended consequences is an adage or idiomatic warning that an intervention in a complex system always creates unexpected and often undesirable outcomes. [wikipedia.org]  In the financial world there are few better examples of a "complexity" than annuity contracts. 

When annuities intersect with trust drafting by estate planning attorneys, expect the unexpected.  A few case histories from the file will illustrate the point and serve as harbinger of advisory challenges.

FROM THE CASE FILES

QUERY.  When you "strap" your client behind the wheel of the next annuity contract, will you do so with the assurance of delivering a safe and rewarding driving experience?

CASE #1:  Exit Ramps


An elderly retiree withdraws $600,000 from his revocable trust to fund the purchase of a deferred annuity.  So far so good; they both avoid probate. 

The advisor matches the beneficiary appointments on the annuity with those listed in the trust; three sons - all with children of their own.  What could go wrong?

One son (with two children) predeceases his father (annuity owner and annuitant) who subsequently dies.

Result.  The two children were pleased to receive their father's share of his inheritance through the per stirpes distribution provisions of their grandfather's trust.  Unfortunately, these same siblings came up $200,000 short of their total potential inheritance.

The reason.  The default contingency provision of the annuity contract beneficiary form provided that in the event of a beneficiary's death, the surviving beneficiaries shall share equally in the death benefit.  The shift from a "per stirpes" to "per capita" distribution format resulted in the disinheritance.  Unintended?  Presumably so.  Unforeseeable?  Presumably not.

QUERY.  Should this occurrence give rise to a potential finding of fault attributable to some member(s) of the advisory community?  If so, who are the possible suspects and under what circumstances might liability arise?

[Side Bar]  Recall that every annuity transaction creates a "shift" of client assets.  No assumption is made that the shift will prove beneficial or detrimental.  However, advisors are encouraged to envision the road ahead and assess possible outcomes.

CASE #2:  Who's Driving?

Financial advisors reading this article will be familiar with this annuity planning and sales promotion.  Irrevocable trusts have long been identified as an ideal source to hold annuities as evidenced by the training and marketing materials produced and issued by advanced marketing departments for prominent insurance companies. 


Departure.  On the promise of additional income, the agent was able to coax the widow (trustee and income beneficiary) to liquidate a $1.5M managed trust agency account held at a local investment advisory firm.

Potential road hazards.  The widow is the second wife of the decedent who has children from a prior marriage.  The children are the remainder beneficiaries.

Front-end collision.  The 5-year SPIA creates annual annuitized payments of $40,600 of which $40,000 is trust principal and $600 trust earnings. 

Road Markers.  SPIA (Single Premium Immediate Annuity); FIA (Fixed Indexed Deferred Annuity); VA (Variable Deferred Annuity) and MF (Mutual Funds)

This representation of one client's perilous journey is being repeated in numerous investors' financial and estate plans.  One primary reason is the use of "bucket portfolios" as the foundation for Income for Life (IFL) portfolio strategies.

[Side Bar]  There is no intent to disparage the use of "bucket strategies" when creating investment and cash flow management programs. They have their place, but not without an advisor's demonstrated knowledge of the design and execution challenges that accompany their implementation.

The creation of investment buckets requires the allocation or deployment of asset value across various components comprising the client's financial resources.  These components often include various trusts and retirement plans that possess distinguishable financial, tax, legal and administrative features and directives which must be reconciled if the "buckets" are to perform as expected. 

In this case, the sales target was a widowed trustee desiring increased income from her deceased husband's credit-shelter trust.  The implementation of a "bucket strategy" with a front-end 5-year SPIA appeared to be the perfect solution.  Annual distributions increased by approximately $10,000, but not without a cost.

    Trustee duty to remainder beneficiaries and compliance with administrative trust provisions.  The trust had distributed $200,000 of trust principal and $3,000 of trust income over a 5 year period to create an average annual payment of $40,600 during the first 5 years.

Unbeknownst to the advisor and individual trustee the trust contained discretionary income and principal distribution provisions.  Those with a basic understanding of trust design, function and compliance can imagine the fall-out that would ensue.

Conflicts soon arose between the trustee/income beneficiary and the children born from a prior marriage of their deceased father.   As remainder beneficiaries, the children were quick to recognize the threat to their future inheritance and "vested" interests.  So was their retained counsel.

    Potential loss of annuity deferral for trust owned contracts.  Recall that the subsequent two "buckets" included a $450,000 FIA and $300,000 VA, totaling $750,000 of deferred and accumulating annuities.

The non-natural person rule generally provides that if an entity, such as a trust (non-natural person), holds an annuity that contract will not be treated as an annuity and that any earnings might be subject to treatment as recognized ordinary income received by the owner.  See IRC §72(u)(1).

The exception.  Where the trust or other entity holds the annuity as an "agent for a natural person," that contract will qualify for tax deferral.  See IRC §72(u)(1)(B).

[Side Bar]  Advisors are recommended to review recently released Private Letter Ruling (PLR) 201124008.  The Ruling provides a succinct overview of the historical context of the Service's rationale for retained annuity status and further explains the reasoning to permit a tax-free and in-kind transfer of an annuity from a trust to a trust beneficiary.  Readers are reminded that PLRs are restricted to the facts as presented by the petitioners. 

QUERY.  Who makes the determination that the trust is holding the annuity as "an agent" for a natural person?

The natural response would be the client's estate planning attorney.  Aside from qualification issues, the mechanics, and fees incurred to engage this solution, the annuity company does have an answer.  Point the finger at the client serving as trustee and the client's tax or legal advisor.

The Escape Hatch or Blanket Release.  Trustee certification forms accompany annuity applications when a trust is to be the designated owner.  Individual trustees typically sign-off on stipulations releasing the insurance company, officers, employees and agents from and against all claims which may arise from the transaction. 

Often included in the fine print is the individual trustee's affirmation the he or she has consulted with appropriate tax or legal counsel regarding any potential adverse tax or other consequences which may arise from the arrangement.

CASE #3:  A U-Turn?

If you have read the first article in the series, you are well acquainted with this financial instrument's various attributes; several of which include estate planning and wealth transfer propositions.  The following slide presents the persuasive appeal of "estate planning in a box."


The passengers.  Jack and Mary are the parents to Frank, who has a daughter - Meg, and Betty, who has a son - Jim. 

The exhibit illustrates projected financial benefits of stretch planning with a non-qualified annuity.

Withdrawal options combined with guaranteed death benefit elections can prove extremely productive - on paper.

The illustration for this contract exhibits formatting and potential outcomes often associated with multi-generation trust schematics with similar attributes which may include probate avoidance, restricted beneficiary distributions and possibly asset protection.

[Side Bar]  Those familiar with "IRA Stretch Planning" will note the similarity with this presentation.  A thorough overview of the concept as applied to non-qualified annuities is found in PLR 200313016.
 
The PLR is a must read to grasp the proposition.  Among other considerations, the Ruling provides an excellent overview of the characterization of annuity distributions, beneficiary withdrawal options and the recognition of income tax liabilities upon the death of owner/annuitant parties to the contract.
In general, the IRS has opened the door to annuity owners and beneficiaries to avail themselves of options and strategies "similar" to those available through Code sections governing the disposition of IRAs; with one very notable caveat.

The Caveat.   A recent advertisement promoting nonqualified annuity stretch planning included a caption informing investors that the "strategy" could not be made available through investors' trusts.  The promoter was correct for reasons that warrant your consideration

One highly versatile component of the annuity contract is the Restricted Beneficiary Designation Form which presents planners with an array of beneficiary distribution options. Contract owners are provided with elections to customize beneficiary entitlements that are often promoted to compete with customized trust arrangements. This includes partitioning of beneficiary share interests via percentage, timing and duration restrictions.  If desired, irrevocable elections can be made.

It is this feature that drives Nonqualified and Qualified Annuity Stretch proposals and a feature which currently trumps options available through annuity trust ownership.

[Side Bar]  Practitioners are generally familiar with the regulations under IRC § 401(a)(9) permitting "look-through trust" arrangements in the qualified plan context, which has been facilitated by the position that the trust can be treated as a designated beneficiary for determination of RMD payments.  See Treas. Reg. § 1.409(a)(9).

Guidance has been sought but not yet issued by the IRS to qualify trusts for similar treatment when annuities are involved.  Pursuant to IRC § 72(s)(4) only a designated beneficiary, which under the Code is defined as an individual, may stretch the payment of the remaining balance of the annuity over lifetime or life expectancy.