A Promising Investment and Cutlery, Too

Would you be interested in a tax-sheltered investment? One that is guaranteed to return your principal to your family if you die? One that your creditors, in many states, cannot touch? What if I toss in a free set of steak knives — now are you interested?

I was only kidding about the steak knives, so put away your billfold. Besides, even though all of the above claims are genuine, these advantages may add up to a lot less than you think. You probably will not want to buy this investment after all.

As you may have guessed, I am referring to variable annuities. These are often marketed as an improvement over ordinary mutual funds, with the “improvement” deriving from the advantages mentioned above. Much less prominent in the sales pitch, though invariably disclosed somewhere in the legal boilerplate, is that these products carry much higher costs than do most mutual funds. As usual, the investor who wants to make an informed decision needs to weigh the increased costs against the benefits.

Annuities are contracts usually sold by insurance companies that entitle the owner (the “annuitant”) to receive payments at yearly or other regular intervals. Traditional or “fixed” annuities provide that those payments will be at specific amounts that are determined when the annuity is purchased. Variable annuities take investment performance into account, so the payment amount is not determined until much later. The annuity may be for a fixed period (e.g., monthly payments for 10 years) or an indefinite period (e.g., annual payments until the annuitant’s death).

Typically, a variable annuity will permit the owner to allocate his investment in the contract among about ten investment options. These options, or sub-accounts, look much like a typical mutual fund family, including large- and small-company U.S. stock funds, international stocks, bonds, stock-and-bond blends, and money market funds.

The tax treatment of annuities is similar to that of a traditional IRA. Earnings on the initial annuity investment are tax-deferred until withdrawn, and withdrawals before the annuitant reaches age 59½ are subject to a penalty, with some exceptions. Unlike a regular IRA, there is no limit on the amount that can be deposited in an annuity, so it can potentially be used to shelter much larger investments from current tax.

Annuity Benefits, Up Close
Since the three most-touted benefits of annuities are tax deferral, guaranteed principal in case of premature death, and asset protection, we want to examine these features closely to see what they really are worth.

The tax deferral feature that is at the heart of the annuity product comes at a price — or, these days, at two prices. First, because annuities have higher annual operating costs (discussed in detail below), much of the economic benefit of the tax deferral simply is offset by those higher costs. To this extent the tax deferral benefit goes to the annuity seller, not the buyer.

Second, any income withdrawn from the annuity is taxed at ordinary rates rather than the preferential rate for long-term capital gains. Since the top federal ordinary tax rate is 39.6% and the long-term capital gains rate currently is 20%, the annuity will often act as a reverse tax shelter, converting capital gains into ordinary income that may double the tax.

Burdened with this double whammy, the tax deferral aspect of annuities is not nearly so appealing, though we still need to consider the issue on a case-by-case basis. Consider this hypothetical scenario: A 45-year-old business owner wants to invest $250,000 for the benefit of her children, who will receive the money 30 years from now. She could put the money in a stock index mutual fund generating 2% current income and 8% unrealized capital appreciation per year before expenses, with expenses of 0.5% (50 basis points) per year. At the end of the 30 years the stock fund would be sold and the gains taxed at 20%. Alternatively she can put the money in a variable annuity returning the same 10% per year, but with annual expenses of 1.5% and an ultimate tax on the growth of 39.6%.

The result: After 30 years the stock index fund yields $2,576,334 after taxes, while the annuity yields $1,844,296 after taxes. This brings up another aspect of the deferral issue: even many fully taxable investments, such as the index mutual fund in this example, are largely tax-deferred if you follow a buy-and-hold strategy. When this is the case, buying high-growth equity investments through an annuity simply gives you a tax deferral benefit that you already had.

Yet another hole in the annuities’ tax protection is that, if you hold appreciated mutual funds at your death, your heirs receive a “stepped-up basis” that forgives the capital gains taxes that accrued in your lifetime. There is no basis step-up for annuities; if you die just before payments begin, your heirs will owe full taxes — at ordinary income rates — on the portion of any payments that reflects the income built up while you lived.

One thing you should never do is roll over an IRA account into a tax-deferred annuity. Since the IRA is already tax deferred, and since you can obtain basically the same investments more cheaply by simply having the IRA buy mutual funds, placing an IRA inside an annuity merely trades inexpensive tax-deferred growth for expensive tax-deferred growth.

‘Insurance’ At A Price
A major reason annuities are such costly investments is a fee, usually about 1%, charged in addition to the investment management and administrative fees. The additional fee pays for what essentially is an insurance policy for the annuitant. If the owner of a variable annuity dies, her beneficiaries are entitled to a “basic death benefit” equal to the amount contributed by the owner less any withdrawals. Any accumulated appreciation is also distributed, but the death benefit guarantees the return of the owner’s contribution, even if the annuity investments have declined since the initial purchase.

This guarantee is a major selling point for variable annuities, especially in times of stock market uncertainty. But is the insurance necessary? While bond and stock markets are volatile, and the odds of decline in the early years are fairly high (the stock market historically declines in nearly one year out of every three), these markets generate very consistent, positive returns over longer periods. The insurance is likely to be valuable only in the unusual situation in which the investor buys the annuity, the annuity investments immediately decline, and the investor promptly dies.

Bells And Whistles
Some annuity issuers add bells and whistles to make the minimum death benefit more attractive. Some companies allow a “step-up” in the amount that is guaranteed to family members. National Integrity Pinnacle Life III sells annuities with this feature. Each year, on the contract anniversary date, the plan locks in the current market value as the minimum death benefit. Let’s say a $100,000 initial contribution appreciates to $120,000 by the end of the first year. If, during the second year, the annuitant dies and the annuity value on the date of death has slipped to $106,000, the beneficiary is entitled to $120,000, the stepped-up minimum death benefit. Of course, the investor must pay for this feature. The expenses for the minimum benefit insurance plus the “step-up” feature are 1.35% per year. Once these insurance costs are added to investment management and administration charges, the total annual cost of investing through the National Integrity product ranges from 1.65% to 2.90%.

Another plan offering a sexy death benefit feature is Equitable’s Accumulator with baseBUILDER. Once you have owned this annuity for at least seven years, the death benefit guarantees a minimum return of 6% annually from the initial contribution, regardless of how your investments have performed. This can be very attractive for a risk-averse, long-term investor. Assume your asset allocation calls for $300,000 in fixed-income instruments but you do not need the income generated by the investment. You could instead place the $300,000 in an annuity sub-account investing in equity funds. After seven years your death benefit would be guaranteed to be worth at least $451,089 ($300,000 grown at 6% annually), so the baseBUILDER operates to turn a potentially volatile equity into, at worst, a predictable 6% fixed return.

As you might expect, this death benefit feature has a catch. The 6% guarantee lasts only until age 80. Thereafter, the annuity owner receives the greater of the market value of the annuity, or the 6% return compounded through age 80. Adding the baseBUILDER feature to the Accumulator costs 0.30% annually. In addition to the insurance expenses of 1.35%, the total expense ratio for this product ranges from 2.20% to 3.40%.

As a result of having such high expense ratios, annuities regularly under perform their mutual fund counterparts. Consider an investment of $500,000 equally allocated among five investment objectives, as shown in Table 1. The table shows the amount that can be saved in the first year by investing in a mutual fund with the same investment objective as a comparable annuity sub-account.

On average, an investor would save $3,500 per year by investing directly in mutual funds instead of in an annuity, not including any differences in sales charges.

How Much Asset Protection?
Doctors, fearful of malpractice lawsuits, and other wealthy individuals seeking asset protection are prime targets for annuity sales efforts, because many states prevent creditors from placing liens on money invested in annuities. Unfortunately, there is nothing to stop creditors from seeking to satisfy judgments from funds that are distributed from the annuities once the owner begins to receive payments. True, a creditor may be loathe to wait many years to be paid, and may not always have a claim when the annuity beneficiary is someone other than the initial purchaser. These factors may be helpful in obtaining favorable
settlements. Still, the asset protection benefits of annuities seem not so great as to warrant the higher costs for most buyers.

To provide an incentive for clients to keep their money invested, most issuing companies add a contingent deferred sales charge, or surrender charge, for any portion of contributions removed from the annuity within a certain period, typically seven years. For example, the Equitable Accumulator annuity’s surrender charge is 7% during the first year and decreases 1% each year for seven years. Any amounts withdrawn after seven years are not subject to surrender charges.

If you pick through the annuity choices, you can find some reasonable investment options. But unnecessarily costly products seldom are wise investments.