Exchange Your Way Out of Bad Annuity
Feel as if you’re locked into a rotten variable annuity--one with high costs and low returns? There is an escape.
Cashing out of an annuity before you reach retirement age can cost a bundle in taxes and penalties. But you can avoid those costs and still transfer money to another annuity by doing something called a 1035 exchange.
In a 1035 exchange--named for a section of the tax code--assets are transferred from one annuity company to another. The annuity proceeds are not distributed to the account holder, so no federal income tax is due.
Doug Fabian, editor of Huntington Beach-based newsletter Maverick Investor, likes to call 1035 exchanges “annuity rollovers,” because they’re similar to 401(k) plan and individual retirement account rollovers.
The company you want to do business with will contact your current annuity provider to launch the exchange. All you need to do is sign a few papers and wait for your money to head to presumably greener pastures.
There are just two caveats.
First, you may have to pay a “surrender” fee to get out of your current annuity. Surrender fees are back-end charges that can range from about 1% to 7% of your account value. (“Back-end” means the fee is paid when you cash out rather than when you buy in.)
The size of the surrender fee probably will hinge on how long you’ve held the annuity and what company issued it. Generally, the longer you hold the investment, the lower the surrender fee. In most cases, there’s no fee after 10 years of annuity ownership, or sometimes after five years. Some newer annuities don’t charge surrender fees.
Before transferring, you should know whether there’s a surrender fee and, if there is, how much it is. But don’t stay in a bad annuity just to avoid the charge, experts caution. Often, you’ll lose more money by staying--particularly if the company has a high annual expense ratio and lackluster investment choices.
The second caveat is that too many people transfer from one bad annuity to another, Fabian said. Typically, instead of investigating their choices, people will simply buy an annuity recommended by an insurance agent, who may be more interested in a commission than helping the client.
Before deciding whether to dump your current annuity--and which one to transfer to--you should consider the following factors:
* M&E; (mortality and expenses). All annuities charge a percentage of the investor’s account value to pay for an insurance component that provides a death benefit. With a variable-rate deferred annuity, the death benefit usually guarantees that the investor’s heirs would receive at least as much as the investor contributed to the account should the investor die in the midst of a market downturn.
However, mortality expenses vary widely. TIAA-CREF, a New York-based financial services company that sells annuities, charges just one-tenth of a percentage point each year for mortality expenses. But the industry average is about 10 times that, said Stephen Murphy, research analyst at Morningstar Investments in Chicago.
What difference can that nine-tenths of a percentage point make over time? For someone with $100,000 invested over a 20-year period, the additional cost adds up to more than $119,000.
In some cases, the higher expenses pay for more insurance. A few companies boost the death benefit to guarantee the market value of the account at set intervals, such as every three to five years, for example. That may be a death benefit worth paying a touch more to get. But higher mortality charges often don’t provide better insurance benefits.
In general, look for the lowest M&E; fee you can find.
* Investment choices. Annuities consist of two parts--an insurance component and an investment component. Generally, the investments offered within an annuity are mutual funds and guaranteed investment contracts.
Some annuities offer dozens of investment choices; others offer only a few. It’s fine to have only a few investment choices, if they’re good ones. But if you want to switch periodically from one type of investment to another, make sure the investment choices you want are available and that the past returns of the funds offered through the annuity are up to industry standards.
Past returns are included in an annuity’s prospectus--a document that is provided to any prospective annuity purchaser. Those returns can be compared with the past returns of similar mutual funds--for instance, growth funds or balanced funds--by looking at industry comparisons in newspapers, magazines and on Web sites, such as Morningstar.com.
* Investment fees. With variable annuities, you’ll be paying investment management fees on top of mortality and administration expenses. The lower the fees, the better your return.
* Surrender charges. All other things being equal, the lower the surrender fees the better.
* Bells and whistles. If you want extras--such as better insurance guarantees, more withdrawal options and computerized account management--ask the annuity companies whether they provide these services and at what cost.
“There may be a feature that you like that isn’t in the other contracts,” said John Wesley, product manager for personal annuities at TIAA-CREF. But be careful about loading your annuity with features you might not use, because they’ll cost you anyway.
“If you start adding features, you can double or triple your expenses very quickly,” Wesley said. “We don’t have a lot of fancy features on the product. We give the best rate we can and we hope that people understand that.”
*
Times staff writer Kathy M. Kristof, author of “Investing 101” (Bloomberg Press, 2000), welcomes your comments and suggestions but regrets that she cannot respond individually to letters or phone calls. Write to Personal Finance, Business Section, Los Angeles Times, 202 W. 1st St., Los Angeles, CA 90012, or e-mail kathy.kristof@latimes.com.
