Tax-Deferred Annuity Seeks Market Gains
How does this sound for an investment? It mimics a major stock market index. It promises a gain even if the market goes down. And it is tax-deferred.
It is the equity-indexed annuity, and it is the latest wrinkle in the rapidly growing business of wrapping investments inside insurance to try to capture the stock market’s heady gains while avoiding current tax.
The market’s performance, along with higher income tax brackets, have made these products an easier sell. Sales over the last decade have climbed tenfold, and many major mutual fund companies, such as Vanguard and T. Rowe Price, have formed insurance subsidiaries to get themselves a piece of the action.
But the stock market, despite nearly a decade without a major drop, remains too nerve-racking for many people. They simply can’t sleep at night if they invest where there is a possibility of losing principal. The equity-indexed annuity is aimed at them.
“We think there is a huge market” among people who want income in retirement but need “stock market-like” returns, said Clifford J. Jack of Jackson National Life Distributors Inc. of Lansing, Mich., one of about 20 companies offering these annuities.
Jack said he thinks the annuities will compete favorably with tax-exempt bonds and will appeal to people receiving lump-sum distributions from pension plans.
But while these and other annuities--especially so-called variable annuities, which are even purer investment vehicles lacking protection against losses--may work for certain people, several financial planners urged caution. Many have high fees, and when distributions start they are taxed as ordinary income, whereas stock market gains can qualify for favorable capital gains treatment.
“You’ve got to be careful with these things because they’re sold like hot cakes,” said Mary Malgoire of Malgoire Drucker Inc. in Bethesda, Md. “I’ve seen many a financial plan where the cost to the consumer [for the plan]was $1,500, except for the $4,000 commission the planner earned off the annuity.”
In addition, she and others warned that even the equity-indexed annuity carries some risk. Terms vary from insurer to insurer, and different contracts can perform very differently, depending on market conditions.
The booming annuity market has arisen because of the special tax treatment accorded life insurance. When a consumer buys a cash-value life policy, the company invests the premiums to get money to pay the promised benefit. These investment earnings are called the “inside buildup,” and they are not taxed.
Annuities’ inside buildup also is not taxed, so insurers realized that by making the benefit a function of the investment performance, they could create a tax-deferred investment device.
Fixed annuities typically pay a return related to interest rates, with the insurer guaranteeing the rate for a certain period of time.
In variable annuities, no return is guaranteed. Instead, the holder is typically offered an array of investment choices and the return depends on the performance of whatever choice the holder makes.
In many ways, variable annuities are similar to 401(k) plans or individual retirement accounts, but without the limits on the amount of money that can be invested. They have proved very popular with higher income people and those in special circumstances, such as small business owners who want to provide retirement income for themselves but are unwilling or unable to establish a pension plan at their company.
Since the investment risk is borne by the holder, variable annuities are legally securities, and sellers of the products must have a securities license as well as an insurance license.
Because equity-indexed annuities guarantee a minimum return--typically 3% compounded annually--they are fixed annuities. They are a current “hot topic” among regulators, according to Barry Barbash, director of the investment management division at the Securities and Exchange Commission, but so far the ones on the market are not securities, he said.
Jackson Life’s Jack said he sees these contracts as appealing to people who now invest in tax-exempt bonds. Although the annuity proceeds are ultimately taxed, recent stock market gains have outrun municipal bonds even after taxes, he said.
Annuities are complex and involve many decisions, though, and equity-indexed annuities are especially complex. If you’re interested, it’s a good idea to consult a financial planner or other expert--preferably one who doesn’t have a financial interest in selling them.
Be sure to consider fees and commissions, and how much your nest egg grows in relation to the index linked to the annuity.
Equity-indexed annuities follow some market index, such as the Standard & Poor’s 500-stock index. But different annuities use different ways of figuring the change in the index.
There are three common designs.
The first is called the “point-to-point” approach. The company looks at the value of the index on the date you buy the contract and then again at the end of the term. The value of the index on the first date is subtracted from the value on the second date, multiplied by a percentage “participation rate”--the amount of the index growth that you get.
Since this is easiest for the insurer to hedge, contracts using the point-to-point system typically have the highest participation rates, said Timothy C. Pfeifer, a consulting actuary with Milliman & Robertson in Chicago. The disadvantage for customers, though, is that the index might be way up during the term but if it falls at the end the customer doesn’t benefit.
In the “high-watermark” approach, the company looks at the index at each anniversary of the contract and uses the highest of these to calculate the gain. This means that if the market surges in, say, year two, the customer locks in that gain even if the index later falls back. These contracts are harder for the carrier to hedge, though, and typically have lower participation rates.
Finally, there is the “ratchet” or “lock-in” approach in which the index is checked annually, and if it has risen, the customer gets that accumulated value for the next year. If it has fallen, it is treated as zero. “The advantage is if the market goes down by a lot you needn’t be as worried about ever getting back on track,” Pfeifer said.
But these are very expensive for companies, so they are most restrictive. Not only are participation rates lower, there may be a limit or cap on the possible gain. And many such contracts allow the company to lower the participation rate at the end of each year.
