If someone hasn’t tried to sell you a variable annuity in
the last few years, count yourself lucky. Variable annuity sales have
risen dramatically in the past decade. Why? Well there are some good
reasons, but mostly on the part of the person selling the annuity,
not the investor!
What is a Variable Annuity?
Traditional, or fixed, annuities have been around a long time. An alternative to a bank savings account or CD, they carried the assurance that you would “never outlive your money.” When you retired, you “annuitized” the annuity, and began taking payments that were set based on your life expectancy. The earnings on the investment were restricted to interest income, at a rate comparable to those CDs. So what is a Variable Annuity? Take the product just described and add to it a choice of investments within the annuity account, allowing the owner to achieve stock market returns.
Advantages are Limited
Most variable annuities are marketed based on tax considerations,
not their insurance features. The primary advantage of a variable
annuity is tax deferral of any income or capital gains that occur
within this account. However, they are only deferred until you start
withdrawing the money, when all that growth is taxed at ordinary income
tax rates, not the 15% capital gains rate! That can double the Federal
tax paid. Those same investments outside an annuity would have received
a step-up in basis when left to heirs, or could be used to gift to
charity. If tax deferral is your primary need, make sure you are fully
utilizing all 401(k), IRA or Roth IRA opportunities first.
Did you say Insurance?
Most policies just guarantee that when you die without having annuitized, you will always receive at least your original investment amount back. Beyond that, the account is not protected against market ups and downs. For this, and the right to annuitize at the current balance later, you are paying an average of 1.3% “mortality expense” per year, every year! Thus total expenses can quickly reach 2.5% or more when you add in the mutual fund expenses and administration! Pretty hefty compared to the average domestic mutual fund at 1.41% in total annual expenses, or about 1% for no-load funds. That would leave a lot of cash to pay capital gains with, wouldn’t it?
The Other Side of the Story.
There are other significant disadvantages to buying a variable annuity that commissioned salespeople from insurance firms, brokerage houses, even your local bank probably won’t mention. They can earn as much as 7%, compared to about a 4% commission for a load mutual fund, a strong temptation. The other major drawback to variable annuities is a lack of liquidity, or access to your money. The surrender charges are generally higher and longer than load mutual funds. Also, withdrawals before age 59 1/2 are normally subject to a tax penalty due to the tax deferral benefit.
There are some situations where buying an annuity makes sense. If possible, seek more objective advice. If you choose to buy one, there are “no-load” annuities that hold the costs down, and those companies won’t be in such a hurry to sell you one!
