Variable Annuities Can Benefit a Few

By KATHY M. KRISTOF

Aug. 19, 2001 12 AM PT

TIMES STAFF WRITER

What’s so bad about variable annuities? Nothing, experts say, as long as you fit within a relatively narrow investor profile.

The profile in a nutshell: a high-income individual who started saving late for retirement and now is in a desperate scramble to catch up.

The reason this is the only sort of person who ought to consider investing through a deferred annuity is simple. For nearly everyone else, there are better options, financial advisors say.

“The investor ought to take maximum advantage of employer-sponsored retirement plans first. Then they ought to open an IRA,” said Farrell Dolan, senior vice president of marketing for Fidelity Investments’ life insurance division in Boston, which sells annuities.

“If they have additional money to save after that, an annuity might fit for a portion of their currently taxable assets.”

Now that the maximum contribution amounts to qualified retirement plans are rising--thanks to the big tax bill passed this year--even fewer people will need deferred annuities, said Steve Norwitz, a spokesman for T. Rowe Price Associates Inc., a Baltimore-based mutual fund company that also sells annuities.

By 2006, a 50-year-old will be able to contribute as much as $20,000 annually to a 401(k), for example. Those who earn less than set amounts also will be able to contribute as much as $5,000 annually to either a Roth or a traditional IRA.

All annuities are essentially a combination of an insurance contract and an investment product. Taxes on investment gains within the annuity are deferred until the money is withdrawn--presumably during retirement--and the insurance portion of the annuity provides certain investment guarantees.

With a deferred annuity, the guarantee usually ensures that if the annuity holder dies when the value of the account is depressed--such as during a downturn in the stock market--his or her heirs will receive at least as much money as was originally contributed to the account.

However, this guarantee comes with a cost. The average annuity charges 1.29% of the asset value each year in mortality and administration expenses--that’s mainly the cost of providing the death benefit. (The death benefit is the guarantee that an investor’s heirs will eventually get what the investor contributed or what the annuity is currently worth, whichever is more.) That’s on top of management fees charged by investments held within the annuity.

Costs Can Easily Outweigh Advantages

The combination of investment management fees and mortality expenses typically consume 2.17 percentage points of the annual investment return each year. That’s about 0.8 percentage points more than the cost of the average mutual fund, said Stephen Murphy, a research analyst with Morningstar Investments in Chicago.

There’s another cost too. In a stock-based mutual fund, the bulk of the profits earned are from appreciation rather than dividends. So when the investment is sold, any gains are taxed at capital gains rates. With an annuity, however, investment gains are taxed at ordinary income tax rates, which are usually higher.

The typical buyer of an annuity is someone in his or her late 40s or early 50s who has put children through college and paid down a mortgage and is concerned about not having saved enough for retirement, Dolan said.

For this person, who is too close to retirement to save relatively small amounts over a long period, the advantage of the annuity is that there is no cap on the amount that can be contributed.

Investors are not hampered by tax laws that limit the amount that can be contributed to other types of tax-favored retirement plans, such as 401(k)s or individual retirement accounts. And over long periods--20 years or more--the ability to defer tax on investment gains earned within the account can be valuable.

On the downside, though, variable annuities lack the most lucrative tax advantages of 401(k) plans and IRAs. Traditional IRAs and 401(k) plans offer upfront tax deductions for each dollar contributed, in addition to tax-deferred compounding. With Roth IRAs, contributions aren’t tax deductible, but withdrawals made at retirement are tax free.

People who buy and hold tax-efficient growth mutual funds, which pass through only nominal capital gains to investors each year, are also usually better off investing in a mutual fund in a taxable account than buying an annuity, Norwitz said.

On the other hand, investors who trade actively and generate a big capital gains tax bill each year or whose portfolio includes a high percentage of income-earning assets--which also trigger higher tax bills along the way--are better off with an annuity, he said.

But even these investors need to shop carefully for a low-cost annuity, or the fees and expenses, combined with the higher tax rate on withdrawals, can make the annuity a net loser over a standard mutual fund in almost every situation, Norwitz said.

T. Rowe Price, which has annuity-analyzing software, says low-cost annuities often provide middle-aged investors with better after-tax returns than a diversified portfolio of taxable investments over the long haul.

However, annuities that charge 1.25% in insurance expenses in addition to about 0.8% in investment management expenses--roughly the industry averages--would rarely beat the after-tax return of simply investing in a standard mutual fund, Norwitz said.

Annuity fees are always disclosed in investment documents, but investors must look carefully, said Brent Kessel, a fee-only financial planner in Santa Monica. They tend to be buried in hundreds of pages of technical legal disclosures about the investment, which few investors bother to read.

“We need a law that says every insurance product and annuity sold needs to have a one-page prospectus where the insurance company tells you the commission paid to the agent, the total annual expenses and the surrender fees,” Kessel said. “They do disclose all this stuff, but it’s all buried in a 300-page prospectus, so no one reads it.”

A list of low-cost annuities is available at https://www.variableannuityonline.com. The Securities and Exchange Commission provides information on annuities at https://www.sec.gov/investor/pubs/varannty.htm.

(BEGIN TEXT OF INFOBOX / INFOGRAPHIC)

An Annuity Primer

Here’s a look at the pros and cons of deferred annuities and immediate annuities.

Deferred annuity

A pre-retirement savings vehicle that allows investment earnings to grow without being subject to yearly income taxes.

Pros

* Investment earnings grow tax-deferred.

* The original investment is protected, regardless of market performance.

* It saves active investors from big annual tax bills on trading profits.

Cons

* Money is locked up until retirement, with penalties for early withdrawal.

* The comparatively high expenses can depress investment returns.