Variable Annuities Worth a Look--for Now

By RUSS WILES

June 20, 1994 12 AM PT

RUSS WILES, <i> a financial writer for the Arizona Republic, specializes in mutual funds. </i>

Variable-annuity investors and the companies that market these products have dodged another tax bullet, the second in three years.

The Office of Management and Budget in April was kicking around the idea of taxing annuity earnings as a way to finance welfare reform. After 250,000 telegrams opposed to the idea flooded Washington, President Clinton nixed the idea during a Cabinet meeting.

Two years before, the Bush Administration included a plan to tax annuities in its budget proposal, but that effort also provoked public resistance and failed.

“Our understanding is that the idea of taxing annuities remains a revenue-raising option” within the OMB, says Jack Dolan, a spokesman for the American Council of Life Insurance in Washington. But for now, anyway, the clouds have lifted.

This means there’s still reason to consider variable annuities--a category of investment vehicles that essentially consists of mutual funds inside a tax-deferred insurance wrapper.

Without the tax benefit, annuities probably would not make sense over regular mutual funds, considering that they’re more complicated and costly. If the tax break is removed, there’s little doubt that variable-annuity sales, which have surged lately, would evaporate.

As investment vehicles, annuities resemble mutual funds. Both are diversified investment pools run by professional managers. Both feature low minimum investments, automatic reinvesting, an ability to switch easily among different portfolios, and other benefits. Many fund families also manage annuities, some of which have names and objectives similar to those of regular mutual funds you might own.

With annuities, you get to defer taxes on income and capital gains until you withdraw the money, presumably in retirement.

For active investors, a handy feature is the ability to make tax-free switches or exchanges among different funds. And conservative investors may appreciate the ability to make tax-deferred investments using a dollar-cost-averaging strategy or a periodic portfolio re-balancing strategy.

MetLife, for example, will automatically re-balance your holdings each quarter to your desired target mix, says Joseph W. Jordan, a vice president at the New York-based insurer. This option provides an automatic buy-low, sell-high discipline, he says.

By deferring taxes on profits and income, annuities thus work like a non-deductible individual retirement account, except that annuity investors can stash away as much money as they want, in contrast to the $2,000 yearly ceiling on IRAs.

Variable annuities are so named because they offer buyers a choice of portfolios that fluctuate in price, according to the behavior of their underlying stock or bond holdings. Fixed annuities, which pay guaranteed rates much as a certificate of deposit would, are also available.

But with fairly low fixed yields these days, variable-annuity sales have pulled even with fixed-annuity sales: Each category took in $36 billion last year, according to member sales figures reported by the American Council of Life Insurance, which represents more than 600 insurers. As recently as 1990, fixed annuities held a commanding lead of $48 billion in sales to $5 billion.

Their hot sales pace notwithstanding, variable annuities are not for everybody because of their higher costs and illiquidity. Most contracts discourage near-term withdrawals--more precisely known as “surrenders”--by imposing back-end sales charges of 6% to 8% for money pulled out within the first year, with the fee gradually declining in successive years.

Insurance-company surrender charges are in addition to a 10% Internal Revenue Service tax penalty that applies to withdrawals made before age 59 1/2.

For this reason, annuities are most appropriate for investors in their 50s or older who have money they can afford to sock away for at least five years, Jordan says.

Jennifer Strickland, editor of the Morningstar Variable Annuity/Life Performance Report in Chicago, advises a minimum 10-year holding period. Because of the cost and illiquidity hurdles, she suggests that investors should first seek tax-sheltered growth through IRAs as well as 401(k) and other employer-sponsored retirement programs.

“Annuities should be your longest-term, least-liquid money,” she says.

Variable annuities, as noted, also are more complicated than regular mutual funds. Not only should you analyze annuities with an eye on investment considerations--the fund’s track record, approach, management tenure and more--but you need to evaluate a slew of insurance features. These include:

* Annuity options. Plans offer various ways to draw monthly payments in retirement. For example, they can be spread over a set number of years, your remaining lifetime, or the lifetimes of you and another person. In part, the higher expenses on annuities go toward lifetime income guarantees that may exceed the insurer’s actuarial assumptions.

* Penalty-free loans. Contracts allow you to borrow some cash penalty-free at any time, but the amounts and interest rates will vary.

* Premium options. You can choose to invest in a lump sum or over time with a flexible premium arrangement.

* Death benefits. If you die before you are to start receiving payments, your heirs would get back at least the money invested (less any withdrawals), even if your investments are showing losses. This is a common guarantee, but some contracts will increase the minimum death benefit beyond that every few years or so.

(Speaking of death benefits, a related product known as variable life insurance works much like variable annuities but with a heavier insurance component. That is, you can purchase much greater coverage.)

Along with their greater complexities, variable annuities also come with higher costs than regular mutual funds. Besides their generally stiff initial surrender charges, annuities impose investment expenses of about 0.77% a year for stock fund accounts, plus insurance costs of about 1.26% annually, Strickland says. These are in addition to contract maintenance charges of about $30 a year.

Expenses on regular stock-oriented mutual funds, excluding any sales charges, average about 1.25%, according to Morningstar.

Strickland cites variable annuities from Vanguard ((800) 522-5555), Scudder ((800) 225-2470), Janus ((800) 504-4440) and Fidelity ((800) 544-2442) as among the least expensive widely available products.

The emergence of less costly contracts, along with a wider range of annuity investments generally, gives buyers a lot more to choose from.

“If you last looked at variable annuities three years ago but didn’t buy anything, you might like something now,” Strickland says.

Profile of Annuity Buyers

What type of people purchase variable annuities? A 1992 survey by the Gallup Organization attempted to answer that question. Some 1,007 annuity owners responded. The results indicate that variable annuities are bought primarily by middle-class investors, including many senior citizens. Here are some results.

Household Income

* Under $20,000: 16%

* $20,000 to $40,000: 29%

* $40,000 to $50,000: 17%

* $50,000 to $75,000: 20%

* $75,000 and up: 17%

Age

* Under 54: 23%

* 54 to 63: 25%

* 64 to 71: 29%

* 72 and older: 24%

Value of Annuity Owned: