Popular Variable Annuities
Aren't Right for Everyone
By Albert B. Crenshaw
(c) The Washington Post
Sunday, September 24, 1995; Page H01
Back in 1986, in its last major overhaul of the tax system, Congress swept away all the personal
income tax brackets but two -- 15 percent and 28 percent.
The idea was to make taxes less of a factor in investment decisions and encourage investors to
focus on underlying economic merit. It was a nice thought, but Congress being Congress, it has
spent most of the intervening years putting new, higher brackets back into the law, and restoring
taxes as a key factor in investment choice.
The added brackets, topping out now at 39.6 percent (plus state taxes, if any), have sharply
increased the appeal of such tax-preferred or tax-deferred investments as municipal bonds and
401(k) plans and assets such as stocks that produce capital gains.
Another vehicle that has taken wing in this environment is the variable annuity, which allows
investors to put money into certain investments, primarily mutual funds, and pay no current tax on
the earnings.
Although you pay taxes on payments the annuity makes you when you get them, some experts see
a big advantage in not paying taxes on the interest your investment makes.
Sales of these annuities have jumped tenfold in a decade -- with half that growth coming since
1993, when the highest income tax brackets were imposed, according to figures compiled by
Cerulli Associates, a Boston management consulting firm.
Despite their tax appeal, though, variable annuities are not for everyone, financial planners caution.
They not only are complex, but there are literally hundreds on the market, with widely varying fees
and other charges that can make them at best inflexible and at worst a downright crummy
investment.
Also, many investors who buy variable annuities don't have a clear idea of what they are trying to
accomplish, several financial planners said.
In fact, officials at T. Rowe Price Associates Inc., the Baltimore mutual fund operator that recently
began offering variable annuities, said they found that the vast majority of people who own such
annuities don't understand them.
The right annuity in the right circumstances can be worthwhile, most planners say. The problem is
figuring out what is "right."
Mary Malgoire of Malgoire Drucker Inc., a financial planning firm in Bethesda, cautioned that
prospective investors should make sure they have "maxed out" other tax-deferred opportunities
such as an individual retirement account and a 401(k) plan, if they have one, before considering a
variable annuity.
Also, investors should be prepared to hold the contract for a long time.
Malgoire said her firm has compared variable-annuity contracts with direct mutual fund investment
and concluded it generally takes six to seven years for the annuity to show an advantage.
Others also advised consumers to be sure of their purpose. Annuities work best for people looking
for retirement income, said Steven Norwitz of T. Rowe Price. They do not work well as estate
planning devices because, while they get favorable tax treatment earlier, they are treated more
harshly in an estate than assets owned directly.
Some advisers remain cool to variable annuities. Kathy Jatras of Organized Finances Unlimited, a
financial planning firm in Arlington, advises many younger clients and finds annuities sometimes get
substituted for life insurance, which she said is a bad idea for young families.
"Generally, I don't think they're very good. . . . The problem is they are variable" and in some
contracts "you can go down below the life insurance face value," she said.
She advises younger clients to buy inexpensive term life insurance and use the savings to fund
401(k) plans and other retirement savings vehicles.
Jatras also is wary of some of the sales pitches that still go with variable annuities. "I'm a
mathematician and it's really scary. {Salespeople} can prove anything" if you don't know what
variables they use in calculations, she said.
It helps to understand what an annuity really is and how it works.
An annuity is a stream of payments over a period of years. There are many kinds -- a traditional
pension is an annuity, for example, and lottery winnings often are paid as an annuity. A fixed
annuity promises a set level of payments at scheduled times; the critical difference with a variable
annuity is that the amount of the payouts depends on the performance of certain investments.
Under federal tax law, the investment earnings are treated like those of a life insurance policy and
are not taxed while they are building up. Taxes are levied, though, when the annuity payments are
made.
In a variable annuity, the amount of the payment is not set in the beginning but is related to the
performance of some investment. The investor can choose among investment alternatives, most
commonly a family of mutual funds, and move the money from one to another as he or she sees fit.
In many ways, such an annuity resembles a 401(k) plan, except that there is an insurance element.
Most provide a death benefit, and all offer a variety of payment options, including one that will last
the rest of your life or to some very old age, such as 90.
Because annuities can be funded in much the same way as life insurance, insurers pioneered the
market. In a traditional fixed annuity, the customer pays a premium or premiums, which the insurer
invests, betting that it can earn enough money to make the promised payments and a profit.
If the tax benefits of variable annuities are appealing, the fee structures of many contracts are not.
In addition to a charge for the insurance component and investment management, they commonly
include a sales charge, or "load"; an annual maintenance fee; and surrender charges -- fees that are
imposed if the customer wants to cash in the contract early.
These often make for a very expensive way to buy a tax shelter.
Recently, though, low-cost operators such as T. Rowe Price, Vanguard and others have entered
the market with more flexible contracts with fewer fees. This has put pressure on the rest of the
market while attracting more buyers.
"More people are aware of variable annuities, and more people are looking at retirement," said
Mary McAvity of Cerulli Associates. "That has driven the {writers of annuities} to look at where
they can provide the most value."
McAvity said the producers are concentrating on consumer education more than in the past, and
on what annuities are useful for, rather than simply the tax aspects.
