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Tax Alpha: A Predictable Strategy for Boosting Retirement Savings

Increasing the total return on clients’ retirement savings may be the biggest challenge for advisors today.

Interest rates and savings rates are low. Risk aversion is elevated and becoming more pronounced – a trend that is closely correlated with above-average price volatility and below-average economic growth. The combination may be holding clients back from building the retirement portfolios needed to support decades of retirement expenses. To exacerbate the problem, the newest tax laws will further undermine the growth of retirement savings.

Broadly speaking, advisors have two options for overcoming the obstacles: pursuing higher pretax returns (alpha) and reducing the net tax exposure on investment returns (tax alpha). Getting clients to the goal of a well-funded retirement portfolio will require creative and skilled use of both, although implementing tax alpha-based strategies, such as the newest generation of cost-efficient, tax-deferred variable annuities (VAs), may be increasingly important and valuable for advisor and client. Built-in tax deferral will help combat erosion by new taxes and can be a more predictable and less challenging approach to amassing retirement funds.

ATRA 2012: More Than Meets the Eye

The American Taxpayer Relief Act (ATRA) of 2012 took effect in January

2013 – to relatively little fanfare or protest. Most discussions focused on the return of the 39.6 percent ordinary income tax bracket and 20 percent capital gains tax rate for the highest-earning taxpayers. However, there’s more to ATRA 2012, as any client in the 28 percent (or higher) tax bracket may now be learning.

ATRA raised tax burdens on many Americans by limiting or eliminating itemized deductions and personal exemptions once adjusted gross income (AGI) exceeds $254,200 in 2014 (for single taxpayers; $305,050 for joint filers). Further, it imposes a 3.8 percent surtax on all forms of investment income for single taxpayers with modified AGI above $200,000 ($250,000 joint for filers). This tax, which is in addition to any other taxes due on investment income, is meant to support the future costs of Medicare.

April 15 may hold some unpleasant surprises for Americans as the total impact of ATRA 2012 comes to light on 1040 forms. Security Benefit analyzed the 2012 and 2013 tax burdens of eight hypothetical investors with total income from taxable investments and wages/compensation ranging from $150,000 to $900,000. The result was an increased 2013 total tax burden for all but the lowest income level, and the increase could be as much as 20 percent for some filers. The total tax due on investment income climbed by as much as 55.7 percent.

Of all the changes wrought by ATRA, the 3.8 percent Medicare tax may well have the most wide-reaching impact. The tax is not indexed for inflation and, like the alternative minimum tax (AMT) before it, could increasingly become a problem for middle-class clients as their incomes grow over time.

New-Generation Variable Annuities: A Well-Timed Innovation

Well before ATRA, providers began reshaping some VAs. In response to lessons learned during the past decade’s financial crisis, the product structure of these new-generation VAs has been simplified. The price structure is more attractive, with fewer and less costly riders and, in many cases, no surrender charges. In addition, these products offer enhanced investment flexibility. A wider array of investment subaccounts and, in some cases, unlimited no-cost exchanges between subaccounts support broad diversification, use of tactical strategies and rebalancing as necessary without triggering taxable events.

These changes, in combination with built-in tax deferral, may make new-generation VAs a more fitting and appealing solution for retirement planning in the present higher-tax environment. Tax deferral can increase annual return pre-withdrawal and total distributions post-withdrawal. And the greater the tax rate, the greater the benefit. Additionally, tax deferral makes it possible to capture these higher returns without pursuing more aggressive investment strategies.

According to Morningstar, to achieve an 8 percent net annual total return, after average fees of 1.39 percent, in a new-generation VA requires a gross return of 9.39 percent. (This is based on the total cost of subaccount net expense ratios and applicable mortality and expense or administration fees of simplified-structure VAs offered by three leading providers, and assumes a $200,000 account balance.)

Generating an 8 percent net total return in a taxable investment requires a total return, after fees and before taxes, of 11.73 percent (28 percent tax bracket + 3.8 percent Medicare tax) to 14.13 percent (39.6 percent tax bracket + 3.8 percent Medicare tax).

If we assume fees of 1.19 percent on taxable investments (i.e., the average annual fee for all open-end mutual funds tracked by Morningstar), the required pretax gross returns are 12.92 percent and 15.32 percent, respectively. Few conservative or moderate-risk investments can consistently generate returns at those levels.

With new-generation VAs, advisors can achieve better returns without assuming commensurate increases in risk. Further, some products offer another feature for the risk-averse – professionally managed investment strategies designed to manage volatility or generate steady returns.

Prepare Clients for Whatever Comes

As mentioned earlier, more than five years out from the financial crisis, client risk aversion remains elevated for several reasons. Higher interest rates are unpredictable; they could be upon us tomorrow or still be years away. Whenever higher interest rates finally arrive, they can be counted on to trigger increased volatility in bond markets. On the equity front, the stock market has had a multiyear run into record territory. How long can it continue to climb?

Even if the capital markets were to stabilize, income taxes remain a threat. Federal (and some state) income tax rates have increased but remain low by historical standards. In the face of record state and federal debt, aging infrastructure and growing demands on Social Security and Medicare funds, what are the odds they may continue to increase? 

A new-generation VA may help you and your clients address these and other changes in the investment market and economic environment that have the potential to threaten the value of clients’ retirement portfolios. At the same time, the more cost-effective VAs available today may help amass retirement dollars while using less aggressive investment strategies and letting easily predicted tax deferral do the work of boosting returns.


Douglas Wolff is president of Security Benefit Life, overseeing product development, pricing and operations. He brings 25 years of experience in investments, financial consulting, actuarial pricing, product development, marketing and strategy formulation to his role. Contact him at [email protected] .

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