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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 their portfolios.

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.

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Defining variables
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 the money.

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 savings vehicles.

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 Minnesota.

-- Posted: Sept. 23, 2003

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