Written by: Matthew Grove and Professor Ira Weiss, Ph. D.
As the Baby Boomer generation ages, financial services companies have found their new reason for being. They have seized upon the image of a mass retirement wave in the U.S. to create an entire “retirement income” industry built on marketing income solutions to retiring boomers. They have been quite successful in this mission—if you pick up any financial periodical, you’re likely to find a headline about retirement income.
Although there’s no doubt that retirement income will play an important role in the years to come, the reality is that the median boomer is 51 years old— fourteen years away from the traditional retirement age. Because of this, the focus of Baby Boomers and the generations that follow would be better aimed at savings accumulation. After all, accumulation is truly the stepping stone to retirement income. The more assets one accumulates during working years, the more income one can generate during retirement.
For many investors, tax deferral should play a significant role in the accumulation process.
By deferring taxes, investors allow gains to compound at a higher rate, creating significantly higher accumulated values over time. These higher accumulated values translate into a more robust retirement income stream, allowing investors to generate more retirement income, over a longer period of time, with a greater possibility of leaving a legacy for their heirs.
Notwithstanding this fact, many advisors underestimate the potential impact of tax deferral on retirement savings. And, many are uncertain how to quantify the value of tax deferral. This uncertainty stems from the fact that it takes a certain number of years of accumulation for the benefit of tax deferral to be realized, and investors with short time horizons may be better off in a taxable account in some cases.
Our analysis suggests that typical mutual fund investors with a moderate risk profile are better off in a low-cost tax-deferred account, rather than a taxable account, if they accumulate for more than ten years before generating retirement income. Conservative investors are better off in a tax-deferred account after just four years of accumulation, and aggressive investors will do better after thirteen years. These results are fairly consistent across a range of assumptions about investor characteristics and behavior.
So, how can consumers and their advisors take advantage of tax deferral? For much of the middle class, 401(k)s and IRAs provide an excellent vehicle for tax-deferred growth. However, the relatively low contribution caps of these vehicles can hamper many higher-earning investors’ ability to save tax-deferred. As a result, many investors have accumulated significant retirement savings in taxable accounts, and would have better outcomes if these assets were shifted to a tax-deferred account.
Variable annuities, which offer tax deferral with practically unlimited contribution limits, can help fill this savings gap.
However, many advisors are suspicious of traditional variable annuities because their insurance costs are significant, averaging over 1.35% of assets annually. These extra costs undermine the basic premise of tax deferral—that assets will accumulate more quickly because returns are compounding at a higher rate—by reducing the compounding rate through the burden of higher investment costs. In fact, our analysis shows that retirement investors with a moderate risk profile would require 31 years of accumulation in a traditional variable annuity in order to do better than a taxable account—far higher than the ten years of accumulation required for a low-cost tax deferred account.
However, new developments in the market—most notably the recent introduction of flat insurance fee variable annuities (“flat fee VAs”), which cost a flat fee of $240 per year, regardless of the amount invested—reduce the costs of investing in a variable annuity to negligible levels. Today, using this new class of variable annuity, retirement investors have almost unlimited access to low-cost tax deferral and can therefore choose to locate their entire retirement portfolios in a low-cost tax-deferred account.
The conclusions we draw from our analysis are twofold. First, advisors should consider moving some taxable accounts earmarked for long-term accumulation into a flat fee VA, as their clients’ after-tax outcome may be better. Second, advisors should review their clients’ existing VAs to determine whether they meet client needs. If a client has a VA because they are looking for incremental growth via tax deferral, their current VA might not be accomplishing that goal. In such cases, advisors should consider making a tax-free 1035 exchange into a flat fee VA. Of course, the current annuity should be reviewed for any loss of benefits or surrender charges that may be incurred.
To read the full, in-depth report, please visit us at Jefferson National here .