Variable annuities: Down but not out
Variable annuities were hot through the '90s, but thanks to new federal tax
cuts, investors are wondering if they should keep the insurance products in
They may be down, but they're not out, according to the experts.
First, the Jobs and Growth Tax Relief Reconciliation Act of 2003
(JAGTRRA) has diminished the value of tax-deferral features of variable annuities.
Secondly, variable annuities can be more expensive investments than alternatives,
such as mutual funds. Still, the income guarantees available with variable annuities
make them appropriate for some people.
Annuity assets totaled just under $1 trillion at their peak in
1999, but by the end of the first quarter of 2003, assets were pegged at $800
million, thanks, in part, to the move in Congress to cut the tax rates on dividends
and capital gains. New sales also have slowed.
Just what are variable annuities?
"An annuity is a contract with an insurance company that
typically provides for tax-deferred earnings," says Mike DeGeorge, general
counsel with the National Association of Variable Annuities, a trade association
in Reston, Va. "Annuities contain a number of insurance guarantees, including
the option to 'annuitize,' or turn the principal into a lifetime stream of income."
They combine elements of life insurance, mutual funds and tax-deferred
retirement savings plans. While their hybrid nature offers investors some features
they can't get elsewhere, it also makes them complicated products.
When you invest, you select from an array of mutual funds in which
to allocate your investment dollars. Typical offerings might include balanced
mutual funds, money market funds and several international funds, among others.
Along with the tax-deferral benefit, you also get income guarantees you can't
get with other investments. For instance, variable annuities, for a fee, offer
a death benefit feature, says James Magner, vice president and attorney with
Lincoln Financial Distributors in Philadelphia.
Say you invest $100,000 in a variable annuity. Over the next few
years, the value of the mutual funds held in your variable declines to $75,000.
Your beneficiaries still would get the $100,000 when you die. On the other hand,
with some death benefit arrangements, if the market value of the annuity has
risen to $125,000, your beneficiaries would receive that amount. A similar declining
investment in a straight mutual fund would mean your heirs would get only $75,000.
Are they right for you?
To decide whether variable annuities are right for your portfolio, you'll first
want to consider the tax-deferral advantage. When you hold variable annuities
in a non-qualified account (that is, your investment is with after-tax dollars),
you don't pay taxes on the income you earn from the annuity until you withdraw
However, when tax rates go down, the benefit of deferring taxes also declines.
With the passage of JAGTRRA, the tax rate on capital gains dropped from 20 to
15 percent. Dividends, which had been taxed at ordinary income rates as high
as 38.6 percent, now also are taxed at 15 percent. Because those tax rates are
lower, it means you would have to hold your variable annuity investment longer
to achieve the same return.
"When dollars are withdrawn from an annuity, they come out
as ordinary income," says David Nye, professor of finance and insurance,
and director of the Florida Insurance Research Center at the University of Florida.
That means they're taxed at higher rates than capital gains and dividends.
In addition, the benefit of the tax-deferral feature varies with
your current tax bracket, and your expected retirement tax rate. If you expect
your tax rate to go down once you leave the work world, variable annuities can
pay off more quickly. However, if you don't foresee any change in your tax bracket,
it will take longer for the variable annuity to out-perform other investments.
Variable annuities also offer some other features that can make
them appealing to certain investors, despite the drawbacks. Most significantly,
many allow you, for a fee, to convert your investment to an annual income stream,
or "annuitize" it. The insurance company guarantees that you will
receive income payments, either for a certain period of time or for as long
as you live.
"Given the high variability in the stock market, and increasing
longevity, it's difficult to guarantee that middle income people will have enough
income to support themselves until they die," says Lewis Mandell, professor
of finance and managerial economics with the University at Buffalo in Buffalo,
New York. "Annuitizing your income can guarantee you money for life."
Variables make good sense if you've already reached the limit
on your other retirement savings vehicles, yet still have money you'd like to
squirrel away, and can part with it long-term. You're not limited in the amount
you can invest in an annuity, as you are with IRAs and some other retirement
One important note: "You never want to use annuities in a
qualified retirement plan," such as a 401(k) plan, says Mandell. That's
because 401(k)'s and other qualified plans already allow you to accumulate money
on a tax-deferred basis. There's no sense in paying the higher costs of an annuity
when you can simply invest in a mutual fund and reap the benefits of deferring
taxes less expensively.
Why the higher price tags for annuities? Insurance companies offering
variable annuities incur the expense of administering and managing the underlying
investments. Also, the company charges for taking on the risk of guaranteeing
a level of income, no matter how the investments perform.
"Most people are better off, if they're going to use variable
annuities, to go with a bare-bones, vanilla, low-cost one," says Ray Benton,
CFP, with Lincoln Financial Advisors in Denver. "But, for some people,
the guarantees are important."
You'll typically want to invest in a variable annuity only if
you can do so long-term. Their tax-deferral feature means they make more sense
over the long haul, Magner says. "When you look at how compound interest
can work, it's to your advantage to stay in a variable annuity for a long time
period. And, it takes awhile for the benefit of deferring taxes to make up for
the generally higher fees of variable annuities."
In addition, rules normally attached to variables make them more
appropriate for long-term investing. If you decide to annuitize your contract,
or receive a stated amount of income for a specific time period, for example,
you may not be able to change your mind later. And, if you withdraw money from
a variable annuity before you've hit age 59 1/2, you'll have to pay tax penalties
of 10 percent.
Karen M. Kroll is a freelance writer based in
-- Posted: Sept. 23, 2003