$tarrBuck Report for September 10, 2006: Variable Annuity?

September 10, 2006

$tarrBuck Report for September 10, 2006:  Variable Annuity?

by R. M. Starr

Variable annuity?
A variable annuity is a hybrid beast:  it’s a mutual fund portfolio living inside a life insurance annuity contract.  Because the annuity includes mutual funds, a securities market investment, disclosure requirements are set by the US Securities and Exchange Commission (SEC).   To get the SEC’s advice to individual investors go to http://www.sec.gov/investor/pubs/varannty.htm  .  For “SmartMoney”’s advice go to http://www.smartmoney.com/retirement/investing/index.cfm?story=wrongannuities  .  For advice from the National Association of Securities Dealers (NASD), go to http://www.nasd.com/InvestorInformation/InvestorAlerts/AnnuitiesandInsurance/VariableAnnuitiesBeyondtheHardSell/index.htm  .

The Hard Sell
Financial professionals often strongly encourage clients to buy a variable annuity.  Why the hard sell?  Variable annuities are often very profitable for the seller.  Sales charges paid to the salesman average 6% of the purchase price (and may be double that).  On a $100,000 contract, that’s $6000 in commissions for a few hours work.  The sales job will include an optimistic projection of profits and withdrawals decades into the future, along with the warning “hypothetical performance shown is not a guarantee of future results and actual performance may be lower.”

Accumulation Period
You pay a lump sum at the start.  The variable annuity invests your money in one or several mutual funds (you choose from the insurer’s menu of in-house funds).   As time goes on, earnings of the portfolio are reinvested.   Considering the time value of money, its no surprise that over time the value of the portfolio can double and redouble.

Why choose a variable annuity?
The obvious alternative to a variable annuity is to hold mutual funds directly.  Why should you hold them through an annuity wrapper?  There are two major attractions of a variable annuity:  lifetime annuity payments; tax deferral during the accumulation period.  The variable annuity, like any annuity using the lifetime payments, can offer an income you won’t outlive.  It’s insurance against outliving your money.  That’s true of any life annuity.   The principal reason for buying an annuity is to insure against outliving your money.   If you’re rich enough or old enough to ignore that risk, an annuity is a waste of money, and thinking about it is a waste of your time and attention.

In addition, the variable annuity — because it is treated as an insurance contract during the accumulation period — acts as a tax shelter.  Profits on the mutual fund portfolio are not taxed during the accumulation period, allowing them to grow with the speed of tax deferral.   Most tax-deferred investments, IRAs, Keoghs, 401(k)’s, 403(b)’s, 457(b)’s, …, have annual limits on contributions.  If you’re really straining for tax deferral, those limits can keep you from sheltering as much income as you’d like.  There is no legal limit on the amount you can pay into a variable annuity.  That doesn’t give you tax deferral on the money you’ve paid in, but all of the profits accumulate tax deferred.

Payout period
During the payout period, starting at a date set in the contract, you can choose to take a lump sum payout, annual payments for a fixed term, or a life annuity.   How much can you reasonably expect?  Remember the power of compound interest.  What if you’d put $100,000 into a variable annuity twenty-five years ago, in 1981, at age 40?  If you chose 100% common stock mutual funds, you could reasonably expect your account now to be worth about $ 1.5 million.  That would support an annual payout of $80,000 to start.  And  the payout would grow with the value of your investment even during the payout period.  If you live for twenty years, to age 85, the payout could total $ 2.4 million.  Is this magic?  The genius of the annuity?  No, nothing fancy.  It’s just the usual miracle of compound interest and the good luck of a bull market in the 1980s and 1990s.

Income Tax treatment
Though the annuity provides tax-deferral during the accumulation period, there are still taxes to be paid.   The most obvious are income taxes.  The growth in value of the annuity is taxed as ordinary income.  Federal tax rates go up to 35%, and state taxes are added on top of that.   A lot of the increase in value of the investment portfolio may have been in the form of capital gains.  But in the annuity payout, you won’t get the advantageous 15% Federal capital gains tax treatment.  All of increase in value is ordinary income.  There will be additional penalty taxes on earnings withdrawn before age 59 and a half.

That’s bad enough.  It can still get worse.  Some states and territories assess premium taxes on the money going into a variable annuity; at their peak, a 4% tax on your investment as it goes into the annuity contract.

Estate Tax treatment
Estate taxes these days are unpredictable whenever Congress is in session.  But if you’re worried about estate taxes, an annuity may be attractive.  A life annuity (over your lifetime or your’s and a spouse’s) takes the cost of the annuity out of the estate.  This is particularly attractive for tax-sheltered money (IRA, 401(k), etc.) which is subject both to estate and income tax and receives no step up in basis (unlike other assets in the estate).

What if I need the money?
Annuity contracts generally allow small withdrawals without penalty.  Larger withdrawals incur a “surrender charge” of up to 7% of the amount of the withdrawal in the early years of the contract, declining to no penalty after many years, sometimes a decade.  Annuity money is locked up.

What are the expenses?
The sales charges have to paid from somewhere: Distribution fee.  Then there are the mortality and expense risks fees, the daily administration fee, and the administrative expenses of the in-house mutual funds.   Investing your money in a variable annuity could cost around 3% a year in fees and charges.   Remember, you don’t have to buy an annuity.   The alternatives include tax efficient index funds with administrative expenses as low as 0.20 % annually.

My money is already in a tax shelter!
Money that’s in an IRA, 401(k), or other tax-deferred defined contribution plan can be rolled over, without income tax liability, into an annuity contract.  But the IRA and 401(k) were already tax-deferred.  There’s no additional tax advantage of rolling them over.  Of course, the salesman receives the sales charge; there is an advantage to the annuity salesman.

Avoiding the hard sell
There are low-fee variable annuities without sales charges available, notably from TIAA-CREF and Vanguard.  If you want a variable annuity, you’ve decided to buy; don’t pay for the sales job.

When’s a good time to buy?
There’s no free lunch.  The cost of the annuity will be larger than the present discounted value of your expected payouts.  How come? Adverse selection — only the healthy buy life annuities so the lifespan of annuitants is longer on average than the typical person’s. The annuity will cost less up front if you buy it when you’re older — but you’ll have less time to receive the payout.

Should I buy a variable annuity with a sales charge?
For most investors, most of the time, prior to retirement, the answer is “no.”

I would not buy it on a train,
I would not buy it on a plane,
I would not buy it here or there,
I would not buy it anywhere.

Tax smart sound investment policy is to max out contributions to tax shelters:  IRAs, 401(k)’s, etc.  When retirement comes, if you want to insure against outliving your money, a low fee variable annuity without sales charge, may be a good investment.  Rolling over the tax-sheltered money into an annuity may be a very sound plan. Like any investment in the financial markets, it will carry risk.  The alternative is a fixed annuity — see the $tarrbuck Report of August 6, 2006.

The hard sell is a tip-off.  If it sounds too good to be true, it probably is.  If it’s too complicated to understand, it’s probably a shell game.

(c) Copyright R. M. Starr 2006

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