Annuities: Gleaning Hard Facts From The Hard Sell

Take the plainest, most conservative investment you can think of. Give it a fancy name, hang some bells and whistles on it, and market it like there's no tomorrow. What have you got? Today's deferred annuity.

Although the recent seizure of Executive Life by California regulators has put the venerable insurance industry in a harsher spotlight, annuities have long been a favorite way to save for retirement. Now, brokers and bankers are joining insurers in pushing these stodgy products as the last of the red-hot tax shelters. But before the promotional avalanche sweeps you off your feet, take a hard look at what these "new, improved" instruments really have to offer.

FAST GROWTH. Annuities still come in two basic flavors: fixed, where interest rates--preset periodically--guarantee steady growth; and variable, where your premium is invested in stocks, bonds, or other assets, and your payout depends strictly on portfolio performance. The difference between immediate and deferred annuities has not changed, either. Immediate contracts are for people who need steady income right away, such as retirees. With deferred accounts, the payout is postponed. All annuities let your money accumulate and grow tax-free until you make withdrawals--the main focus of most sales pitches.

What's new is that insurers are enhancing their products to lure people who might otherwise put money in mutual funds. For example, North American Security Life offers Venture, a combination fixed and variable annuity that lets investors pick among 12 portfolios with a wide variety of instruments and risk levels. No matter which you choose, its marketers gush, your money grows exponentially faster than if it were taxed yearly.True. But one reason variable annuities are being sold so energetically is that their fees grow exponentially, too. On top of an annual administrative fee, annuities carry risk or "mortality" charges of 1% to 2% a year. This protects the insurer if you live so long that you collect more than the value of your account. You're billed another 1% to 2% for money management. And if you should need your funds in an emergency, heavy "surrender" charges apply for early withdrawal, normally starting around 6% in the first year and declining a point a year thereafter. All these fees add up to more than you would usually pay a mutual fund, where expenses average roughly 4% for load funds. Unless you hold the annuity for at least 10 years, the costs outweigh the benefits of deferring taxes--especially if you tap your money early. "It's not an easy calculation to make," says Robert Coplan, director of Ernst & Young's national tax department in Washington.

Fixed, or "guaranteed," annuities aren't pushed quite as aggressively as variables these days because they don't generate such rich commissions. But banks, insurers, and others are hyping them as a tax-deferred alternative to certificates of deposit. For the risk-averse, fixed annuities are attractive: Your principal is guaranteed, and insurers generally pay a point or two more than banks do on CDs.

TABLE POLISH. Here, too, make sure to read between the lines. Ads typically show a graph illustrating how much faster a fixed annuity grows than a taxable CD. But that skyrocketing line is your pretax money. The minute you touch your annuity, you start paying taxes on it, too. Since the ads never point this out, customers are seduced by a chart comparing apples and oranges. "What they're really selling you is a compounded-interest table," says Mark O'Brien, a financial planner with O'Brien, Greene & Co. in Swarthmore, Pa.

So who should consider annuities? Financial advisers say these instruments are best for conservative investors who: one, are willing to lock up their money for the long term; two, want to put away more pretax dollars than permitted by IRAs or company 401(k) plans; three, like the option of getting regular retirement income; and, four, are fairly sure they'll be in a lower tax bracket when they take distribution. "The longer the time frame, the less susceptible you'll be to a tax increase in the future," says Steven Weinstein, a partner at Arthur Andersen in Chicago.

Even investors who fit that profile should fund their 401(k) plans to the maximum first, tax experts say. Such accounts carry no charges or fees, and most companies fully match pretax contributions up to 3% of your salary and partially match as much as 6%. That makes these plans No. 1 in the return-on-investment hierarchy, says Weinstein.

BOND TIME? Next come deductible IRA contributions, for those who are still eligible. With your aftertax dollars, weigh the annuity choices carefully against, say, municipal-bond funds with good track records. If you want access to your money, are willing to take a little more risk, and don't feel you need another retirement account, a bond fund will probably yield the better return.

Finally, if you do pick an annuity, remember that "solid as a rock" no longer describes the insurance industry, as Executive Life's junk-bond portfolio shows. Check company ratings with A. M. Best, Moody's, Standard & Poor's, and Duff & Phelps. Independent Advantage Financial in Los Angeles produces an "honor roll" of fixed-annuity issuers, available by calling 800 TAX-CUTS. The Insurance Forum newsletter lists the companies that have been rated A+ for the past 15 years.In the universe of tax-deferred investments, annuities have a place. But if you're thinking of buying one, check out all your other options first. Remember, growth stocks are a tax-deferred investment, too.

Before it's here, it's on the Bloomberg Terminal.