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Trying to Tame Annuity Sales

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Times Staff Writer

Is a tax-deferred annuity a good investment for you?

If two insurance trade groups have their way, all investors will discuss that question with their insurance agents before buying.

The American Council of Life Insurers and the Insurance Marketplace Standards Assn. recently announced a push to extend “suitability” protections to every consumer. These protections require insurance salespeople to consider an investor’s time horizon, assets and goals before recommending an annuity.

A handful of states, including California, have instituted these protections, but only for investors age 65 and older. This is the first time that insurance agents would be required to discuss the issue of suitability with buyers under 65.

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But there’s a catch: Neither insurance organization -- nor the National Assn. of Insurance Commissioners, which has been pressing for laws on disclosure and annuity sales practices since 2003 -- has any authority to make it happen. In the last three years, only 11 states have moved to protect seniors from abusive annuity sales. And just eight states require detailed disclosures of the pros and cons of an annuity.

Even though financial experts say that tax-deferred annuities are rarely a suitable investment for anyone, the products are gaining popularity. In 2004, the last year for which statistics are available, $224 billion in tax-deferred annuities were sold, more than twice the sales from 10 years earlier.

Tax-deferred annuities are designed to allow people to save money for retirement on a tax-deferred basis. Money put into an annuity is contributed with after-tax dollars, and the income it earns is tax free until the money is withdrawn.

Within the account, annuities are similar to a 401(k). Investors get a range of mutual funds and other options to choose from. They may put their entire investment in one option, or divvy up their money among a variety of options within the account.

It sounds good on its face, but for most people “a tax-deferred annuity never makes sense,” said Mark Wilson, a financial planner at Tarbox Equities in Newport Beach.

Scott Leonard, a certified financial planner with Leonard Wealth Management in Redondo Beach, agrees. Although annuities may be good for the rare individual, he says, he hasn’t found such a person in the last 15 years.

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The big drawback: the costs.

First, the annuity obtains its favored tax status by including an insurance element, which promises the buyer a death benefit guarantee. But that benefit comes at a cost: The typical annuity includes so-called mortality and expense charges, which can add up to 0.5% to 1.5% annually.

Another cost is the big tax bite. Although investment income isn’t taxed as it accumulates, all that income is taxable when it is withdrawn at retirement. Moreover, it’s taxed at ordinary income tax rates, which can be as high as 35%, not capital gains rates, which currently top out at 15%.

If money is taken out before age 59 1/2 , the withdrawal also can be subject to penalties.

The combination of mortality and expense charges and the higher tax rate make annuities a high-cost investment.

Most planners say that the average consumer would do much better by buying a stock index fund and leaving that money alone until retirement. Index funds generate minimal taxable income each year, they’re low cost, and when the money is withdrawn, the gains are taxed at preferential capital gains rates.

“The costs of an annuity are a humongous drag on a portfolio,” Wilson said. “You add in the ordinary income tax rate on withdrawals, and it’s very hard to make it work out.”

Some experts say that the numbers don’t tell the whole story, however.

“When you add personal psyche into the equation, you find that some people like the fact that they bought a whole package, it’s tax deferred and it’s growing,” said Christine Fahlund, senior financial planner at T. Rowe Price, a Baltimore-based provider of mutual funds and annuities. “Are the fees worth it? I don’t know.”

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Fahlund said a good analogy was people who like to get big income tax refunds, which don’t earn interest. “If you run the numbers, they don’t make any sense. And yet a lot of people love it when they get a refund.... We don’t always behave in the most logical way.”

Moreover, insurers say that one reason annuities make sense is that they lock up the consumer’s money until retirement. Without financial penalties, some consumers would simply spend the money they put in mutual funds and would retire poor.

Leonard disagreed.

“I would agree that people make silly mistakes all the time,” he said. “But your job as a financial advisor is to counsel them into making better decisions, not to tie their hands with a bad financial product.”

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Kathy M. Kristof, author of “Investing 101” and “Taming the Tuition Tiger,” welcomes your comments and suggestions but regrets that she cannot respond individually to letters or phone calls. Write to Personal Finance, Business Section, Los Angeles Times, 202 W. 1st St., Los Angeles, CA 90012, or e-mail kathy.kristof@latimes.com. For previous columns, visit latimes.com/kristof.

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