Annuities: Don't Believe The Hype
Have you bought a variable annuity yet? If you're a baby boomer and your answer is no, get ready for the hard sell. The promoters of these savings vehicles will prey on your insecurity about not having enough money for retirement to get you to sign up for what could be a costly investment. Even if you already have a variable annuity, someone may try to convince you to trade in your existing contract for one with new bells and whistles -- in which are buried higher fees. The problem with variable annuities is they are often a high-cost answer to a problem that may have simpler, cheaper solutions, such as fully funding your tax-deferred retirement accounts or assembling a portfolio of reliable dividend-paying stocks. Still, through Sept. 30, 2004, variable annuity sales were $98.4 billion, about 4% higher than during the same period in 2003. And it's insurance salespeople, not Wall Street brokers, who are making most of the sales. Financial planners in particular have been cool to the product. Variable annuities "are tax-inefficient, difficult if not impossible to understand, and have high costs," says Warren McIntyre, a financial planner in Troy, Mich.
Sure, potential buyers can ignore the sales fluff and dig into the fine print to figure out if an annuity is right for them. But that can be a real slog: The prospectus for MetLife's (MET ) Preference Plus Select Variable Annuity runs over 500 pages, so you know why most buyers wind up relying on a sales spiel.
The legions of sales folks are spending time and money to refine their pitches. In February, for instance, at the annual marketing conference of the National Association for Variable Annuities (NAVA) in Tucson, one session will cover, according to the program, "the hot buttons that drive baby boomers' long-term financial decisions and how to connect the benefits of variable annuities to these hot buttons." NF Communications of Walnut Creek, Calif., a sales training firm, offers a marketing system over the Internet that teaches salespeople how to find affluent seniors and get them to exchange annuities they own for new ones that throw off a slew of new fees. By doing so, says NF's Web site, you "can sell two to four additional annuities a month" with an average commission of $2,500 each. Commissions on these annuities run 5% to 7%, says the NAVA, which, in the investment world these days, is a pretty big number.
As aggressive sales practices rise, so has the number of disgruntled buyers pleading their case to regulators. These annuities "have received more than their proportionate share of complaints, compared to their sales," says Mary Schapiro, vice-chairman of the NASD, the regulatory body formerly known as the National Association of Securities Dealers. Customers made some 7,000 complaints about variable annuities in 2003, says the NASD. The regulator has not yet compiled the 2004 numbers, but says the complaint level remains high. Jim Poolman, North Dakota's insurance commissioner and chairman of the Life Insurance & Annuities Committee of the National Association of Insurance Commissioners, says his group was so concerned about "churning" -- getting annuity owners to swap their old annuities for new ones -- that in 2003 it wrote a model law that makes the annuity salesman responsible for assuring the product is suitable for the prospective buyer. The law has so far been adopted in five states.
What exactly is this product that so many are eager to sell? A variable annuity is a contract with an insurance company designed to beef up your assets before you retire. You buy the annuity, either with periodic payments or in a lump sum, and then invest the money by choosing from a selection of stock, bond, and money-market funds, or in annuity parlance, "subaccounts." It's a "variable" annuity because the returns vary depending on how the underlying investments perform. Many variable annuities also offer an option of a minimum guaranteed rate of return.
At some point, perhaps when you're ready to retire, the idea is that you annuitize the cash you've accumulated over the years. That is, the insurance company will pay you a monthly fixed sum based on the value of the nest egg, your age and life expectancy, and whether you want to retain any income for your beneficiaries. But only about 1% of variable annuities are ever annuitized. Most people leave the money in the variable annuity, and withdraw it as needed.
In many respects, the variable annuity sounds like a mutual fund, but it has key differences. First, if you die, the insurance company promises to give your beneficiaries at least the amount you invested. That's why in addition to the ongoing investment management fees of a mutual fund, the annuities levy a "mortality and expense risk charge" which pays for that life insurance-like feature. The average M&E charge is 1.01% a year. Another option is an enhanced death benefit, which will increase the guaranteed payout to your beneficiaries -- say, an extra 5% a year. Of course, that adds to the cost.
The variable annuity also differs from a mutual fund in that the investment earnings, like those of a 401(k) or individual retirement account, are tax-deferred. You pay the tax when you start taking the money out of the account -- and you can do that at age 59 1/2 without incurring a penalty. Unlike the other tax-deferred retirement plans, the annuities have this advantage, and there's no limit to how much you can stash away.
That tax deferral was a critical selling point for many years, but now such deferral may be unwise for many investors. Here's why: If you invest your annuity in stocks, they'll produce both long-term capital gains and dividends, which right now are taxed at a maximum rate of 15%. But long-term gains and dividends earned in the annuity will eventually be taxed as ordinary income, usually at a much higher rate.
Annuities come with a host of fees and conditions. The average annual expense for a variable annuity in 2003 was 2.32% of the value, says the NAVA, compared with 1.4% for an equity mutual fund. Another cost that may come into play if you want to break the contract is the surrender charge. That's an early withdrawal penalty which declines over a specified period. For example, you may pay 7% of the annuity value to get out the first year, 6% the second year, and so on until it reaches zero after seven years.
As a consumer, the best way to arm yourself against the pressures of annuity marketers is to know the common sales pitches and how to respond to them.
A variable annuity is the most tax-efficient way to save for retirement once you've maxed out your 401(k).
Not so. If you're subject to a marginal income tax rate of 28% or higher (for a couple, that's taxable income of $119,950), you will likely be better off putting the money you would have invested in an annuity into some well-chosen stocks or mutual funds in an ordinary taxable account. Sure, you pay taxes as you get dividends or earn capital gains, but they'll be, at most, taxed at the 15% rate. With the annuity, those profits could be subject to much higher rates.
It pays to trade in your old annuity for a newer, better version.
Annuity marketers say if you're a healthy retiree, expecting to live quite a few more years, you should trade in your old annuity to get one with some of the features that weren't available when you purchased your old contract, such as the guaranteed minimum withdrawal benefit. That benefit ensures that you can withdraw a certain amount, say, 7%, of your principal a year, even if the value of the account has gone down. The feature adds 0.25% to 0.65% a year in costs. However, entering into a new contract not only drums up new fees, it forces you to lock up your money for a certain period. You also may face a schedule of stiff surrender fees.
A variable annuity is the best way to guarantee your income will last as long as you live.
By definition, the value of a variable annuity fluctuates with the performance of the underlying investments. An annuity without an income guarantee runs the risk of declining in value if the markets slump. Such guarantees can add 0.30% to 0.75% a year in costs.
You're going to need an annuity when you retire, so you'd better buy it now.
You don't have to buy a variable annuity now to get annuitized income later. At any point, such as when you retire and take a lump sum out of your 401(k), you can purchase an immediate annuity, either fixed-rate or variable.
A variable annuity is a good way to transfer wealth to your heirs.
An annuity allows you to say who will receive whatever proceeds are left when you die. However, your heirs will have to pay ordinary income tax on the money. If you bought a life insurance policy instead, the money would pass along tax-free.
In the end, you still might want a variable annuity. But make that decision after careful consideration of the product and alternative solutions -- not because someone pressured you into it.
|Corrections and Clarifications "Don't believe the hype" (Personal Business, Feb. 7) refers to NF Communications, a company that sells training programs to teach annuity salespeople how to find affluent seniors who might want to buy or exchange an annuity. President Larry Klein says the program advises salespeople not to encourage exchanges unless it is to the client's advantage.|
By Ellen Hoffman