Variable annuities were once the hottest thing going in the investment business. Despite the horrible battering they’ve received in the press, they sold like crazy even last year–a whopping $87.8 billion worth, up almost 18 percent from 1996.
Then came the bad news. The 1997 tax law cut capital-gains tax rates on long-term investments to as low as 10 percent and left ordinary income tax rates the same. This made mutual funds more attractive, since the income from an annuity isn’t considered a capital gain.
Sales of variable annuities fell 2.6 percent in the first quarter of 1998 compared with the fourth quarter of 1997.
All this raises the question: Do variable annuities make sense for anyone anymore?
A variable annuity is essentially a mutual fund in a life insurance wrapper. You pay a lump sum up front or structure a series of investments as you see fit; money can be put into stocks, bonds or mutual funds (each vehicle is known as a sub-account). You then set up a series of payouts, usually to start at a specified later date.
Your assets are guaranteed by a death benefit–if you die before collecting all of your money, your estate will receive at least as much as the initial cost of the annuity.
Your returns are not guaranteed (hence “variable” versus “fixed” annuities), but you are allowed considerable freedom to select where the money goes.
Unlike a mutual fund, which incurs capital-gains taxes each year, a variable annuity allows you to invest tax-deferred– meaning you put funds into one now and pay income taxes later as you receive the money. You can also transfer money from sub-account to sub-account without creating a taxable event.
To help spur sales, the variable annuity industry has made moves over the past year or so to cut its charges and fees.
John Hancock Mutual Life introduced its MarketPlace Variable Annuity, which has lower mortality fees and no surrender charges. Mortality expenses often run about 1 to 1.5 percent of the annual value of the policy and pay for the guaranteed death benefit; MarketPlace’s mortality fees are just 0.75 percent.
The lack of surrender charges means that buyers no longer have to pay hefty fees to withdraw their money early, though other expenses still apply.
Fidelity, USAA and Vanguard have also lowered their mortality expenses. Variable Annuity Research and Data Service (based in Marietta, Ga.) expects sales of variable annuities to increase this year by 10 to 15 percent.
Despite these positive steps, most people still should not buy a variable annuity as an investment or an insurance vehicle.
Their fees are too high–2.09 percent a year on average, more than 40 percent higher than the fees on the average mutual fund.
And the insurance coverage is negligible–you have to die while the account value is underwater for the death benefit to be worthwhile.
Still, the tax-deferred aspect entices the uninformed.
“People have such an aversion to taxes that they will buy anything, including variable annuities,” says Meir Statman, a finance professor at Santa Clara University in Santa Clara, Calif., who studies investor behavior.
“How useful will they be? Who knows? It depends on your situation when you cash it out.”
Here are five scenarios that might help to make sense out of variable annuities:
– You’ve hit the limit on retirement contributions.
Investing in a variable annuity is a great way to stash cash tax-deferred if you’re investing the maximum in your IRA and your 401(k) or Keogh plan. If this is the case, make sure the next scenario also applies to you.
– You have an extremely long investment time horizon.
Don’t think you can tap the kitty for a rainy day, like paying for your child’s college education, buying a second home, or purchasing a Jaguar. The typical surrender charge is steep–7 percent if you cash out in the first year, declining a percentage point every year until it gets to zero by the seventh year.
If you bail out before you’re 59 1/2, you’ll also have to pay a 10 percent tax penalty. Figuring in all the fees, the break-even point for a variable annuity with respect to a mutual fund used to be seven to ten years. With the 1997 tax law, it’s now more like 15 years.
So plan on holding on for 20 to 25 years, says Lynn Hopewell, a financial planner in Fairfax, Va. “It takes a long time to make it pay off,” he says.
– You think you’ll need the income in retirement.
Have you lived the high life? Sent your kids to private schools? Taken fancy vacations? Bought expensive toys? Haven’t stashed away enough money for retirement? Then you may need those monthly annuity payouts later.
Buy a deferred annuity now, which pays off down the road a ways, and switch in retirement to an immediate annuity, which starts paying instantly. But remember: The monthly income payment you receive will fluctuate with the value of the underlying fund.
– You’re fiftysomething and single with no dependents, or your spouse or heirs don’t depend on you for financial assistance.
Peter Katt, a life insurance adviser in Kalamazoo, Mich., likes to give the example of Maxine Potter, a fictitious college professor who’s making good money from two books she has written.
A widow with no children, she wants to retire early and buy a house in Tucson so she can play golf all year. So, starting at age 53, she plows $1,200 a month in extra income into a deferred variable annuity and then, at 62, transfers it to an immediate variable annuity, which sends her a check every month–for life. “That way, she’s maximizing her income for when she needs it later,” Katt says.
– You might be sued or have to file for personal bankruptcy.
This is an extreme case, of course. But many states, including New York, Florida, and Texas, protect some assets in variable annuities from creditors. Doctors susceptible to malpractice lawsuits, take heed and see your attorney.
If any of these cases applies to you and you decide to buy a variable annuity, then shop around. Many companies offer no-load–i.e., no sales commission–variable annuities with zero surrender charges.
Among the best-performing: Janus Retirement Advantage, Vanguard Variable Annuity Plan, and Ameritas No-Load Variable Annuity. Also, respected teachers’ pension-fund system TIAA-CREF plans to offer a no-load variable annuity to the general public next year.
Finally, do some homework. Morningstar (800-735-0700), the mutual fund research firm, can give you an independent appraisal of a company’s financial strength, charges and fees.
