Variable annuities are the stealth investment: Many own them, but few will admit to it. The insurance industry's answer to mutual funds, variable annuities get little respect. They largely deserve that fate. True, annuities allow you to delay taxes on your earnings. But in turn, you pay higher expenses, tie up your money longer, and complicate your retirement and estate planning. Worse, half of all annuities are sold to confused 401(k) and individual retirement account savers, who end up paying extra for a tax-deferred investment in an account that already postpones taxes.
To shed its bad reputation, the annuity industry is hitting the market with a raft of new products. Fees are falling, savers are getting new and cheaper ways of reclaiming the cash that they've invested, and insurers are offering better guarantees against investment disasters. "This market is finally coming around to consumerism," says Stanley Hargrave, a planner and consultant at IMS/CPAs in Riverside, Calif.
These innovations improve the odds that a variable annuity could serve as a useful addition to your retirement nest egg. But don't reach for your checkbook without a thorough analysis (table). You'll only want to consider an annuity if you've maxed out your other tax-deferred savings, such as 401(k)s and traditional or Roth IRAs. And you'll need to devote effort to mastering the Rube Goldberg complexity of annuities' many parts. An annuity, warns accountant James A. Shambo of Lifetime Planning Concepts Inc. in Colorado Springs, Colo., is "a complex product that only a few people can use well."
FASTER GROWTH. A variable annuity is an insurance policy wrapped around a set of mutual funds. The mutual funds, called "subaccounts," resemble the choices you'd get from a fund family, ranging from stock indexes to money funds. Unlike 401(k) contributions, annuity premiums are paid with aftertax dollars. But your earnings aren't taxed immediately, so they grow faster. You pay for that break in three ways. First, you face a 10% tax penalty if you spend earnings before age 59 1/2. Second, when you do withdraw funds, all the earnings are taxed as ordinary income--even those that accrued as capital gains. That can double the tax on stock gains.
Then there are the fees. The average variable annuity charges a steep 2.11% of assets each year, according to Morningstar Inc. Mutual fund expenses average 1.37%. The difference: Insurance costs, primarily a charge known as mortality and expense, or M&E, that covers death benefits and insurers' sales costs. Morningstar figures that M&E and other insurance costs average 1.27% on top of fund expenses of 0.84%. Insurers pay less for funds because they buy in bulk. But between fees and the lost capital-gains tax break, most variable annuities may need 15 years to match the aftertax performance of a taxable account.
JOLT AHEAD. Insurers' fat fees created an opening for mutual fund giants. They sell annuities directly to investors, eliminating the 6%-plus sales commissions insurers pay agents. But annuity pricing will get a jolt in October, when TIAA-CREF, the big pension fund for academics, rolls out its new Personal Annuity Select nationwide. The product will feature total costs of just 0.37%. TIAA-CREF calculates its annuity can outperform even a low-cost mutual fund in just six years. The annuity at first will offer just one subaccount, a stock index fund. TIAA-CREF will add a bond fund and three more stock funds next year. "We're selling annuities as a simple product with low costs," says Chairman John H. Biggs.
Besides cutting its own fees, TIAA-CREF is pushing a study that says insurers charge too much for an annuity's guaranteed death benefits--the promise to return your premiums when you die, even in a bear market. "Even in the worst cases, a basic guaranteed death benefit is worth only 11 basis points," or 0.11% of assets, says Moshe Arye Milevsky, a researcher at York University in Toronto, who did the study.
ESCAPE HATCH. One reason insurers charge more is to provide escape hatches for investors fearful of locking up funds forever. Fidelity Investments, the biggest direct seller of annuities, announced Sept. 7 that investors can elect a richer death benefit. Fidelity will guarantee that an annuitant's estate can collect the highest value of the account on any previous anniversary of the account's opening, even if the funds have slumped since. Investors who choose that feature will pay 0.2% a year on top of Fidelity's 1.76% average fee. Fidelity also joined a growing list of issuers to eliminate surrender charges. These fees, usually 5% to 7%, are levied when an investor cashes out an annuity in its first seven years. Insurers use the charges to help cover commissions. Direct sellers, notably Vanguard Group and T. Rowe Price, led the way on wiping out the charges.
As baby boomers age, sellers are starting to focus on the second stage of an annuity's life: the payout. An annuitant can pull out all the accounts' funds--paying a sizable tax bill in the process--or take occasional withdrawals. But insurers hope more investors will opt for "annuitization"--taking their proceeds as a stream of monthly checks. These payments can be fixed or variable; in either case, they're guaranteed not to fall below a minimum amount during the life of the owner. (Joint annuities are also available to cover the life of the owner and a spouse or heir.) Issuers argue that today's fortysomethings, lacking defined-benefit pensions, will crave a guaranteed income source.
Annuitization hasn't caught on, largely because investors don't want to surrender control of their money. T. Rowe Price addresses that fear with its new Income Account immediate annuity, which starts paying out at once. The fund lets investors pull out without penalty in the account's first five years. John Hancock Mutual Life Insurance tackles another retiree fear with a new annuity that, for an additional 0.35% annually, pays extra if the owner or a spouse goes into a nursing home or needs home health care. For most retirees, however, long-term care insurance would be cheaper.
Do consumers want more features? Shane Chalke, president of AnnuityNet.com, says annuities "won't become a mainstream investment until they're simpler." His Leesburg (Va.) firm sells basic annuities--with fees averaging 1.29% and usually no surrender charges--via the Internet. Indeed, the Net also teems with annuity advice. The info you gather will help you arm yourself to understand fees, surrender terms, investment choices, and payout options. If the industry can keep cutting annuities' fees and boosting their flexibility, investors might even be willing to admit to owning them.