Are Variable Annuities Right for You?

Tax worries have set a great herd of investors looking for relief. Many have found it in municipal bond funds, but others are pushing on toward variable annuities.

If you can imagine an investment that offers the main advantages of mutual funds together with tax-deferred growth, you will understand why variable annuities have become popular.

Sales shot up 77% to $14 billion last year, estimates Lipper Analytical Services, a financial research firm.

Sales were helped early in the year by an ill-fated Bush Administration proposal that would have curtailed the tax benefits for new purchasers of variable annuities. Later, the market reacted to President Clinton’s call for higher taxes.

Another factor was the trend toward lower interest rates in 1992, which made competing fixed-rate annuities less appealing. Because variable products offer a choice of bond, stock and combination portfolios, investors have a chance to earn higher returns, albeit with greater risk.

Variable annuities are contracts sold by insurance companies, typically through insurance agents, stockbrokers or financial planners. The contracts offer a choice of payout options, such as an income stream for as long as you live or for a set number of years.

In the meantime, you invest your money in any of several diversified, professionally managed portfolios that closely resemble mutual funds and, in fact, often are run by fund companies.

Earnings accumulate tax-free until withdrawn.

Despite the lure of tax-sheltered compounding, variable annuities aren’t for everybody. They typically come with higher fees than regular mutual funds, and buyers will find them to be rather costly vehicles from which to withdraw money if they must do so on short notice.

Answers to the following questions can help determine if variable annuities are right for you.

* Are you in a high tax bracket?

The big appeal of variable annuities is the ability to defer paying taxes on income and gains.

“Obviously, there would be more benefit from tax deferral if you’re in a higher bracket,” notes Jennifer Strickland, editor of the Variable Annuity/Life Performance Report from Morningstar Inc. of Chicago.

* Are you taking full advantage of individual retirement accounts and employer-sponsored retirement programs?

Annuities offer tax-sheltered growth, but you can’t deduct the amount you invest. By contrast, money put into IRAs may qualify for both benefits.

And many employer-sponsored retirement programs such as 401(k) plans are even better, assuming your company will contribute dollars into your account, as many do. Incidentally, you can typically hold mutual funds in either an IRA or an employer-sponsored plan.

“The advantage of annuities is that there’s no limitation on the amount of dollars you can invest, unlike with an IRA or 401(k),” says Geoffrey H. Bobroff, a senior vice president in Lipper’s Denver office.

“But it’s wise to fill up your other (tax-sheltered) buckets first,” he says.

* Are you willing to put up with higher fees?

Annuity contracts come with insurance costs that make them more expensive than regular mutual funds. These costs pay for two types of coverage.

First, if you die at a time when your account is showing a paper loss, your heirs will get back at least what you put in. Second, if you choose to collect a lifetime stream of income, you would continue to receive money for as long as you live--even if it’s for a lengthier period than the insurance company estimated.

“This type of payout is popular among people who worry that they will outlive their savings,” says Mel Young, an agent with Prudential Insurance in Phoenix, Ariz.

Still, both protections cost money. In addition, most annuity products are sold by commissioned salespeople, so they carry higher marketing costs than no-load mutual funds.

In short, you can expect to pay total expenses on variable annuities of about 2.2% a year, according to a recent Lipper study, compared with 1.2% on mutual funds.

* Are you willing to stay put for the long haul?

Most variable annuities, unlike most mutual funds, impose back-end sales charges to discourage early withdrawals. A typical charge might start at 6% or 7% on money pulled out during the first year, declining by one percentage point annually after that, Strickland says.

Two annuities that don’t impose sales charges are the Scudder Horizon Plan (800-242-4402) and the Vanguard Variable Annuity Plan (800-522-5555).

Because variable annuities are more complex than mutual funds, most buyers require the help of a salesperson, Bobroff says.

Earnings on money pulled out of annuities by investors who haven’t yet reached age 59 1/2 generally would be subject to a 10% tax penalty, as well as ordinary income taxes.

This also applies to cash taken out of IRAs and employer pension plans, but not taxable mutual funds.

Funds vs. Annuities

For tax-sheltered growth, variable annuities are attracting a loyal following. These products offer many of the advantages of mutual funds, coupled with some unique features.

Here’s how variable annuities stack up against mutual funds. The comparison includes tax-sheltered funds--those held in individual retirement accounts or employer-sponsored retirement plans.

Tax- sheltered Mutual mutual Variable funds funds annuities Professionally managed Yes Yes Yes Diversified portfolios Yes Yes Yes Choice of asset categories Yes Yes Yes Ability to switch among portfolios Yes Yes Yes Price fluctuations likely Yes Yes Yes Tax-deductible investments No Yes No Tax-sheltered compounding No Yes Yes Insurance coverage No No Yes Upside limits on amount invested No Yes No Early-withdrawal tax penalty No Yes Yes

Notes: Price fluctuations are likely except on money market mutual funds or fixed-rate portfolios within variable accounts. IRA investments may or may not be deductible, depending on your income and pension plan coverage. Early-withdrawal tax penalties apply to people below age 59 1/2.