An Annuity For Folks Of All AgesJeff Laderman
If there ever was a financial product whose time has come, it's the variable annuity. The product, which combines the investment potential of mutual funds and the tax-deferral attributes of insurance, would appear to be a winner, especially for baby boomers, many mf whom are facing two sobering realities--middle age and higher income taxes.
Now, you may think annuities are for old folks. But if you want to have a lifetime stream of income in your golden years, you need to start saving early. The annuity helps build that nest egg. Unlike mutual funds or bank accounts, the dividends, interest, and capital gains realized within the confines of an annuity are not taxed during the accumulation period.
"MAXING OUT." What makes the annuity "variable" is that the return varies depending on what kind of investment program you select. Under the traditional or "fixed" annuity, the insurance company determines the rate of return. Over time, however, well-managed variable annuities are likely to beat fixed accounts by a handy margin.
But the variable annuity is not for your first dollar of retirement savings. If you qualify for a defined-contribution plan such as a 401(k) or an individual retirement account, it's in your interest to "max out"--or contribute the maximum amount of pretax dollars you're entitled to under the tax code. Then, you may also want to consider putting money into a nondeductible IRA or making aftertax contributions to your 401(k) plan. Both vehicles have lower expenses than do variable annuities.
But they have their drawbacks: They require that you start withdrawing money by age 701 2; annuities will usually allow you to delay withdrawals until age 85. The 401(k) offered by your employer may not have the variety of investment options available in an annuity. And both the aftertax IRA and 401(k) have maximum contributions. With the variable annuity, there's no limit to what you can salt away, as a lump sum or through periodic investments.
As with all retirement plans, be sure you can afford to leave the money invested in an annuity until age 591 2. Early withdrawals can be expensive. First, the IRS exacts taxes and a 10% penalty on the accumulated earnings. There may also be a "surrender charge."
The variable annuity is a tax-saver because all the taxes on interest, dividends, or capital gains are deferred until the investor starts to draw on the account. That won't happen for years, at the time the annuity owner is retired and presumably in a much lower tax bracket. Consider that the marginal federal rate for couples with taxable income of $140,000 is likely to climb to 36%, and those making more than $250,000 will be hit with a surcharge that raises the rate to 39.6%. And that doesn't count state and local taxes. If you're likely to drop into the 31% or 28% bracket as a retiree, the savings can be substantial.
COMPLEX INSTRUMENT. But if the idea behind the variable annuity is simple--tax-deferred investing for retirement--the variable annuity is a complex instrument as well. That's why most annuities are sold by brokers, financial planners, or insurance agents. But not everyone who sells annuities carries every variation. The danger in relying on one person or investment firm is that the best variable-annuity contract for you may not be available.
Variable annuities have their critics. Arnold M. Rosenbaum, a New York financial consultant, notes that annuities, like taxable mutual funds, often generate capital gains. But when the money is withdrawn from an annuity, it's always taxed at ordinary income tax rates, not the 28% capital-gains rate.
Most investors can still beat the aftertax return on mutual funds using the variable annuity. To make an informed decision, investors need to understand both the investment and insurance features of the annuities, or what's sometimes called the "wrapper."
If you're already a mutual-fund investor, the investment part is easy. The selections under the annuity behave an awful lot like mutual funds; in fact, many are clones of well-known funds, run by the same manager. The average variable annuity offers about seven choices, including stock, bond, money-market, and specialized funds. Each is called a "subaccount."
To keep track of a subaccount's performance, annuity owners follow the "accumulation unit value" (AUV). Similar to the net asset value of the mutual fund, the AUV is calculated by measuring the change in the value of the investment, adding the portfolio's income and realized capital gains, and subtracting management and insurance expenses.
HEAVY TOLL. The main insurance cost is the "mortality and expense" charge, which pays for the "guaranteed death benefit." That feature assures that if you die during the annuity's accumulation years, the value of the annuity to your beneficiary will be at least as much as you put into it. Some annuities offer a "step-up," which extends the guarantee beyond your contributions to part of the accumulated earnings. The "M&E" charge, as it's also known, can run anywhere from 0.55% to 1.40%. Enhancements such as increasing guarantees usually mean higher M&E charges. Atop the M&E, the insurance company levies a contract charge, usually a flat fee in the $25-to-$40 range, that covers the cost of administering the annuity. On a $25,000 annuity, a $25 contract fee is a scant 0.1%.
All told, investment- and insurance-related expenses can exact a heavy toll. Average expenses for variable annuities run about 2.12%, according to The VARDS Report, a publication that tracks variable annuities. That's nearly one percentage point more than on mutual funds. But then again, taking 1% less per year in return may be a fair trade-off for tax deferral.
Annuity investors can face sales charges as well. But there are ways to dodge them. First, don't buy any annuity that levies an up-front "load." Most annuities have surrender charges as high as 9% that decline by one percentage point a year and disappear after five to ten years. Don't surrender, and you don't pay. Look for annuities that have no exit fees such as the Galaxy Variable Annuity sold by Fleet Financial Group or variable annuities offered by two mutual-fund companies--Scudder, Stevens & Clark and Vanguard Group.
Expenses are important, but your selection should be determined by the investment features--not fractions of a point in annual costs. "What's so great about paying less in fees if you're getting less in investment return?" asks Tom Whalen, research editor for Morningstar Variable Annuity/Life Performance Report.
Likewise, investors should choose annuities for their investment-opportunities program and not for the payout options, which may not come into play for decades. When it's time to annuitize your variable annuity--exchange it for a lifetime income--you don't have to do it with the insurance company you've had for years. The IRS lets you transfer tax-free between insurers at any time. You also have the option of withdrawing your money in a lump sum or periodic installments without ever annuitizing.
It's also advisable to choose an annuity backed by a well-capitalized, highly rated insurance company. But if the company fails, your funds won't be lost or frozen. Unlike fixed annuities, variable-annuity subaccounts are legally separate from the insurer's general accounts.
Getting a fix on variable annuities isn't easy--there are more than 160 annuity contracts with nearly 1,000 subaccounts. And unlike stocks and mutual funds, you can't turn to the daily newspaper or stock quote terminal for investment returns.
WORTHY EFFORT. If you're pleased with your mutual funds, ask the fund company about a variable annuity with similar offerings. Many fund managers have their own program or can lead you to annuity contracts for which they manage subaccounts. Another route is to seek an annuity such as those offered by Nationwide Life Insurance and Life Insurance Co. of Virginia with subaccounts run by Fidelity, Oppenheimer, and other well-known mutual-fund managers.
You may want some independent information as well. A subscription to Morningstar's report on variable annuities is probably overkill, but a single copy is only $15. Call 800 876-5005. The VARDS Report sells a single issue for $49 but will send a free sample if you write to Box 1927, Roswell, Ga., 30077-1927, or call 404 998-5186.
Reading up on variable annuities takes effort. But when you're choosing an investment you may have for the rest of your life, it's an effort worth making.
A VARIABLE-ANNUITY GLOSSARY An annuity is a contract between an investor, or the annuitant, and an insurance company. The variable annuity differs from the standard or "fixed" annuity because its value fluctuates with market conditions. It has the potential to earn much higher returns than fixed annuities. Investors salt away money for years. No taxes are paid on profits until the funds are withdrawn. Interested in investing? Here are some terms you'll need to know. ACCUMULATION UNIT VALUE The equivalent of price per share, or the net asset value of a mutual fund. It's calculated by measuring the change in the value of the investment, adding the portfolio's dividend income and capital gains, and subtracting the management and insurance expenses. CONTRACT CHARGE An annual charge, usually in the $25-to-$40 range, paid to the insurance company for administering the annuity contract. GUARANTEED DEATH BENEFIT Insures that, in the event of the annuity investor's death, it will be worth at least as much as the investor contributed. This feature protects against downward market fluctuations. Some annuities "step up" this benefit periodically to include the earnings. MORTALITY & EXPENSE CHARGE The percentage of the annuity's assets the insurance company deducts to insure the guaranteed death benefit. SUBACCOUNT The investment portion of a variable annuity, analogous to a mutual fund. SURRENDER CHARGE A fee, usually a percentage of assets withdrawn, levied for withdrawing funds in the first five to ten years of an annuity contract. DATA: THE VARDS REPORT, MORNINGSTAR INC., BUSINESS WEEK