Variable Annuities Offer Insurance, Investment
The variable-annuity juggernaut keeps rolling along, picking up tax-weary investors along the way.
Sales of these insurance-investment hybrids remain strong this year after a 58% surge in 1991 and a 51% gain in 1990. The numbers are a bit misleading, since mutual fund sales in general have done nearly as well lately.
But there’s little doubt that enthusiasm for variable annuities is on the upswing, with more choices available than ever before.
As investments go, variable annuities are fairly complicated and restrictive, and thus don’t make sense for everybody. In short, they are mutual funds wrapped in a tax-deferred shell, with some modest insurance coverage sprinkled in.
The insurance protection amounts to a guarantee that your heirs will get at least what you invested, even if you die with your account showing a paper loss. This promise isn’t why people purchase variable annuities, though. They buy them for tax reasons.
With annuities, all capital gains and dividends build up tax-free until you make withdrawals. At that point, ordinary income tax is applied to the earnings, along with a 10% penalty for withdrawals before age 59 1/2.
“They’re better than an individual retirement account for some people, because you don’t have to start taking distributions by age 70 1/2,” said Michael W. Butt, an investment executive in Paine-Webber’s Scottsdale, Ariz., office. You might have to begin withdrawing money by age 85, however. Because of the 10% tax penalty, Butt considers annuities most appropriate for people who are already 55 or older.
However, you can’t deduct the amount you put into an annuity, which makes them less valuable than IRAs and employer-sponsored pension plans such as 401(k) and 403(b) programs. Most of these non-annuity retirement accounts allow mutual funds as an investment choice.
“In almost any instance, an IRA or 401(k) is more appropriate, especially if your employer will match your contributions,” said Jennifer Strickland of the variable products department at Morningstar Inc., a Chicago research firm.
Many employers kick in 25 cents to $1 for every dollar a worker invests in an in-house retirement plan. If you have taken full advantage of these more attractive retirement programs and still have money left over--the annual contribution limit is $2,000 a person for IRAs and $8,728 this year for 401(k)s--then annuities might make sense. You can put away as much cash as you want in these products.
Before you invest, make sure you won’t need the money for five years, perhaps longer. Annuities impose higher fees than regular mutual funds, so it takes longer for the tax benefits to offset this drag. Besides the investment advisory and other fees that mutual funds charge, annuities add insurance costs--which run about 1.25% a year on average, according to Morningstar.
More important, the vast majority of variable annuities, unlike most regular mutual funds, impose surrender charges, essentially back-end loads to compensate brokers or other salespeople. These charges phase down and out over time but can start as high as 10% on withdrawals made during the first year.
Of more than 100 annuities tracked by Morningstar, only three have no sales fee. They are Mutual of America’s Separate Account 2 (800/468-3785), Vanguard’s Variable Annuity Plan (800/522-5555) and Charter/Scudder Horizon (800/225-2470).
Because of the insurance fees they charge, variable annuities are at a modest performance disadvantage compared to regular mutual funds.
Otherwise, you can expect comparable investment results.
According to Strickland, about a third of all annuity portfolios are, in fact, managed by mutual fund companies. Insurers run most of the rest. The same person might pick stocks or bonds for both an annuity and a regular mutual fund, but the two products won’t be identical.
“You won’t get the same entity, but you can buy a similar investment strategy, often run by the exact same manager,” Strickland said.
Most variable annuities let you choose from three to six portfolios, including at least one in the stock, bond and money-market categories.
Many contracts also offer more exotic selections, such as global-bond or real estate funds.
Annuities also offer other services and features associated with mutual funds, including dollar-cost averaging, systematic withdrawals, low minimum investments (usually around $5,000) and telephone switching among portfolios.
In short, annuity portfolios and mutual funds are nearly identical--aside from the insurance and tax ramifications.
Advantage: Mutual Funds
In terms of performance, regular mutual funds enjoy a modest edge over mutual funds available within variable annuities. The difference results from higher overall expenses, including insurance fees, charged by annuity portfolios. Below are average yearly returns, in percent, for selected categories of regular mutual funds (MF) and variable annuity (VA) portfolios for the period ending May 31.
5-Year Return Category 1-Year Return (Annualized) Aggressive Growth (VA) +12.99 +8.42 Growth (VA) +9.34 +8.54 Growth (MF) +10.10 +9.44 Growth & Income (VA) +8.96 +8.78 Growth & Income (MF) +10.15 +9.00 International Stock (VA) +5.86 +3.46 International Stock (MF) +8.95 +5.88 Balanced (VA) +10.19 +8.37 Balanced (MF) +10.98 +8.66 Bond (VA) +7.90 +7.32 Bond (MF) +11.24 +9.23
Source: Morningstar Inc.
