As a young man, I was a crewmember of a 747 that crashed on takeoff in Kenya. The airline's emergency planning helped me keep cool, think rationally and help save the lives of 90 of the 149 passengers.Today, as principal of a financial advisory firm in Irvine, Calif., I regularly see people approach retirement planning like an airline flight, hoping the unthinkable won't happen. But while the chances of a crash are remote, the financial markets are considerably less predictable. Few are prepared for the transition from earnings income to portfolio income.

I urge clients to ponder the unthinkable. What happens to their portfolio if there's a severe or prolonged market downturn? Will they have to change their lifestyle? Will they have to delay or forego retirement?


When shifting from earned to portfolio income, generally the most important consideration is having sufficient income until death. Since longevity is as unpredictable as the markets, there's enormous responsibility for advisors to guarantee an adequate income stream for life. One effective strategy involves the use of a new generation of variable annuities.

I know that seeing a VA in a client's retirement portfolio probably makes you cringe in disgust. In the past, it only made sense for clients in a high tax bracket who had maxed out their 401(k), IRA and other contributions. But it was obscene for someone to have a VA inside a qualified account.

Today, it's a different story.

The new VAs are actually more appropriate in a qualified retirement account when guaranteed income for life is the goal. That's because using VAs to generate income in a non-qualified account - as opposed to buying mutual funds or stocks - creates the potential for converting long-term capital gains treatment into ordinary income. Distributions from a qualified account are treated as ordinary income anyway, so qualified accounts may now be the most appropriate vehicle for VAs with guaranteed income benefits.


It goes without saying that the client should be instructed to carefully review the product prospectus, but we have an obligation to our clients to go far beyond that caution and fully explain the nuances of the VA product under consideration.

VAs are complex instruments. The annuity contract, fees and charges, investment options, death benefits, minimum income and/or withdrawal options are important issues. Feature and benefit comparisons between VAs and other investment options should also be discussed with clients.

Among the new VAs, those most useful in retirement planning are probably the guaranteed minimum income benefit and guaranteed withdrawal benefit. The GWB may be the most useful, as it ensures a lifetime income stream while providing an opportunity for portfolio growth through market participation. It's designed to provide a steady and reliable income stream, irrespective of volatility or overall market performance. Funding can be through a variety of investment products, and asset allocations can be modified. Investment principal is guaranteed, as is an annual "step up" in the value of the account, typically 5 percent. Taxes are deferred until distribution.


All VAs come with caveats. Advisors must ensure that clients understand the nuances, in addition to matching products with client needs. VAs do not come cheap. Typical fees are 1 to 1.5 percent higher than average no-load mutual funds. Over time, this can be significant.

Are the new VAs worth it?

Consider a client retirement portfolio mix of mutual funds averaging 11 percent annually. If these investments were sub-accounts inside a new VA, generating the same raw performance, the retiree would likely receive only 9 or 9.5 percent average return because of the cost of the insurance. However, he has a guaranteed income stream for life. Is this assured benefit worth somewhat-diminished portfolio performance? Obviously, that can only be answered on an individual basis. The retiree's capacity for risk is an important consideration.

Some VAs represent better buys than others. VA sponsors differ in how they treat excess distributions. When an investor takes excess distributions, problems can occur. Depending on the performance of the account, excess distributions can result in depletion of the guaranteed income base and subsequently the guaranteed income itself. Worse, the client continues to pay a premium - which could be as much as an additional point or more - for a guarantee benefit that is no longer in force. Guarantees are based on the claims-paying ability of the issuing insurance company, so diligence in choosing a product sponsor is vital.

If a $1 million VA retirement account with a GWB at 6 percent ($60,000 annually) suffers a market loss of 50 percent, the value of the account is reduced to $500,000, but the retiree can continue to withdraw $60,000 annually for life, providing that amount is not exceeded. If the retiree withdraws $100,000 one year, the guaranteed benefit base may be reduced by $200,000, not the $100,000 withdrawn. That's because in some contracts, excess distributions reduce the guaranteed account balance "pro rata."

That means the $100,000 distribution was deducted from the account's actual value, which has dropped to $500,000 because of the poor markets, not the original guaranteed benefit of $1 million. The investor's guarantee is now reduced by $200,000 to $800,000, and the 6 percent annual distribution now provides $48,000.

Another retiree bought a VA with a money-back guarantee after seven years. The choice was fine unless she took a distribution, which she did in an emergency. That negated the money-back guarantee, and so she must now sweat out the remaining years of the contract, hoping her stocks don't drop. Clients' time horizons must match the VAs they purchase.

Another consideration is that withdrawals prior to age 59-1/2 may be subject to a 10 percent Internal Revenue Service penalty. Surrender charges may apply, and withdrawals may be taxed at the current ordinary income rate.


Advisors selling VAs can take an up-front commission or an ongoing service fee from product sponsors. Commissions provide little incentive to monitor clients' progress over the years to make sure that they don't inadvertently abuse or invalidate VA provisions.

I believe the industry would be better off if the sponsors did not even offer upfront commissions, which would force advisors to rely on trailing income, in turn forcing better client service. It would also help clients avoid making errors when purchasing VAs or otherwise compromising their investment objectives.


As advisors, we tend to focus retirement strategy on optimizing investment returns. However, investing is not the goal, just the vehicle. The goal is replacing earned income with guaranteed income for life - a point that is often lost. Studies show that the optimal asset mix to last a lifetime is 80/20 equities over fixed income, assuming a 5 percent annual withdrawal rate. But good odds notwithstanding, there's always the chance of running out of money. Getting retirees to accept the optimal mix can be difficult, depending on their tolerance for volatility. What often happens is that risk-averse clients choose a less-than-optimal portfolio mix with a higher chance for failure.

VAs with guaranteed income benefits allow retirees to choose the most appropriate asset mix, even if it may involve greater volatility or if portfolio performance is less than hoped, because their income is guaranteed for life. This can make retirement planning much easier for advisors, as retirees have more flexibility and less stress in choosing an investment mix.

Submitting retirement portfolios to emergency planning is one way to prepare for unforeseen contingencies. Variable annuities can be a valuable facet of this contingency planning, provided that advisors invest the time to learn their nuances and complexities, correctly match the appropriate VA and benefit rider to client requirements, and ensure that the strategy is being employed in a long-term planning environment.

Tom Scott is a registered principal with and offers securities through Linsco/Private Ledger. Reach him at

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