Special Report: Investing in Retirement

Just Say No To Annuities

Tax-efficient funds are a better bet

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While variable annuities guarantee your principal -- that is, if you die with your account underwater, your heirs will get all of your money back -- the most heavily pushed feature of these investment products is that they shield your investment gains from taxes. Indeed, the tax deferral alone is enough to sell novice investors an annuity on the spot. "Most people, as soon as you mention they can save on taxes, their eyes light up and they want to do it," says Ileen Malitz, a financial planner and former Rutgers University finance professor who guides clients into mutual funds instead of annuities. "People think the goal is to minimize taxes and not maximize return."

However, there is a simple strategy that can minimize taxes and investment fees and maximize returns in the process. Rather than putting, say, $100,000 into a variable annuity, put that amount into a stock index fund or a tax-efficient mutual fund. Granted, you will have to pay taxes on your investment gains along the way, but the lower fees and lower taxes when you finally withdraw the money will more than make up the difference.

Consider: If you put $100,000 into a variable annuity that earns 10% a year for 20 years, before fees, after a fee of 2.11% is subtracted, your account will be worth $456,692. The same amount invested in a tax-managed fund that earns 10% -- and generates a tax liability of 1.8% a year and annual fees of 0.20% -- would leave you with $466,096 after 20 years.

But that's just the beginning. When you withdraw the money from the variable annuity (assuming a 39.6% rate), you'll owe $110,575 in taxes, leaving you with $304,246, and an investment gain of just $204,246. In real terms, that's a return of just 5.7%. (If the money is taxed at a more modest 31% rate, the real return rises to 6.4%.)

On the other hand, when you cash in your tax-managed fund, the taxes (based on a long-term capital-gains rate of 20%) will be just $73,219. That means what you keep, including the original $100,000 investment, works out to $392,877. The annual return: 7.1%.

But forget those percentages. What that really means is that by investing in an index fund rather than a variable annuity that earns exactly the same return, you end up with $88,631 more money for retirement than you'd otherwise have.

On top of that, your investment won't be subject to the onerous rules of the insurance company and the federal government. Let's say you absolutely need to get your hands on your investment money after three years. If you've invested in an index or tax-efficient fund, you'll be subject only to capital-gains taxes, virtually all of which will be on long-term gains. If, on the other hand, you have invested in an annuity, your gains will be subject to ordinary income taxes, plus, if you are under 591/2, a 10% federal penalty for early withdrawal.

The punishment doesn't stop there. Insurance companies typically levy a stiff "surrender charge" on money pulled out early, usually within six to eight years of purchase. This back-end charge, which starts at about 6% and declines over time, compensates the broker and insurance company who weren't able to collect the fees they had expected over time.

That surrender charge is, in effect, a telescoped version of what happens to your investment returns over time. They are gobbled up by the insurance company (which is why, as we point out in the story, "No Fear ," the stocks of annuity sellers are probably good investment opportunities). The extra expense in the annuity comes from its insurance component, called mortality and expense, or M&E, which averages 1.28% of assets.

Sellers say most of that extra fee goes to paying for a death benefit, essentially insurance that protects your principal investment should you die unexpectedly while holding an annuity. This guarantees that when you die, your heirs will be paid the higher of the market value of the investment or the amount you initially invested. Insurers push the death benefit as downside protection and, to be sure, it provides some psychological comfort, but the perk has rarely been tested during the stock market's historic bull run.

Determining the true worth of the death benefit would require juxtaposing the odds of the market falling during an extended period of time and you dropping dead in the same span -- a longshot for most.

Number-crunchers estimate that the death benefit is worth next to nothing. Moshe Milevsky, a finance professor at York University in Toronto and an insurance consultant, says the benefit is worth 0.05% - 0.07% when viewed purely as an insurance contract, about 1/25th of what insurance companies charge. On whether investors should consider the death benefit, Milevsky says, "It depends on how old and sick and risk-averse you are."

So, where does the money for the M&E fee really go? Mostly to line the pockets of the seller. A little more than half of it, some 0.60% - 0.80%, goes to the sales agent, the rest goes toward administration, advertising and other sales functions, says Thomas Mitchell, an independent insurance consultant.

If a tax shelter and insurance against dying at a loss aren't enough to persuade you to buy an annuity, the next concept a seller might try is annuitization. This refers to a method of drawing lifelong payouts on a monthly or quarterly basis. The feature provides what sellers tout as "guaranteed income for life."

Insurance companies started promoting this option heavily in 1997 when the long-term capital-gains tax rate was lowered to 20% from 28%, making the tax-deferral offered by annuities less attractive. But few annuity owners -- about 1%, according to the Life Insurance Marketing & Research Association -- have chosen to annuitize, largely because the payout system is rigid. In most cases, once you annuitize, you can't draw down more from your account than your predetermined payment.

In effect, the only true advantage annuities have over mutual funds is that they allow investors to switch portfolios without triggering capital-gains taxes. A single annuity contract lets investors choose among anywhere from five to 30 subaccounts that invest like mutual fund portfolios. Annuity contracts allow you to move money around freely within the subaccounts, while moving money from one mutual fund to another triggers a taxable gain.

If you feel you need the flexibility to do this -- and remember, you can move the money around in your 401(k) and IRA plans to your heart's delight, if that is your bent -- there are a handful of low-cost providers out there. No-load mutual fund giants such as the Vanguard Group, Fidelity Investments and T. Rowe Price Associates all offer annuities with annual fees about one-fourth to one-half of the industry average, and none levy surrender charges. Fidelity sells its own annuities through a life insurance subsidiary, while Vanguard and T. Rowe partner with insurance companies Aegon USA and Security Benefit Life Insurance.

But the cheapest way to buy an annuity appeared on the scene last year in the form of TIAA-CREF, the massive pension system for educators that is now offering mutual funds and variable annuities to the public. TIAA-CREF, which runs some $285 billion, mostly in annuities, offers its Personal Annuity Select product, which offers a portfolio tracking the Russell 3000 stock index or a bond portfolio that promises at least a 6.25% annual return. It includes no sales or surrender charges or maintenance fees.

V ariable annuities, like life insurance, are sold, not bought. Look no farther than the fact that almost half of the money in variable annuities is held in qualified retirement plans like IRAs. That's right. Investors have been hornswoggled into paying exorbitant fees -- 1.28% of assets annually on average -- to get tax-deferred status in an account that's already tax deferred.

We're talking big money here -- roughly $500 billion -- most of which made its way into IRAs from other retirement plans, like 401(k)s and 403(b)s. That means investors are paying annuity firms some $6.4 billion a year in unnecessary fees - money that is, in turn, shared in commissions with the brokers and financial planners who advised their clients to roll their retirement plans into variable annuities in the first place. Indeed, so rampant is the problem that in 1998, the National Association of Securities Dealers put out a notice requiring registered sales representatives to advise clients that the "tax-deferred accrual feature of the variable annuity is unnecessary" in a tax-sheltered retirement plan.

For their part, annuity makers insist that their products are appropriate within tax-deferred plans. "People need to have the benefit of the death benefit to ease their fear of the equity market," says Peter Cummins, who heads up sales and marketing for retirement products at Hartford Life.

Consider, too, that the conventional wisdom about variable annuities is that it takes decades for them to break even with a comparable investment in a taxable mutual fund on an after-tax basis. In other words, if an investor is to gain any advantage -- a specious prospect at best -- he has to buy them when he's relatively young. But according to Limra International, an insurance-industry consulting firm, about 40% of annuities are sold to people nearing or past the age of retirement. Indeed, buyers age 65 and older bought more than one-half of the annuities sold outside of tax-sheltered qualified plans.

"It's a travesty," says Tom Batterman, a financial planner based in Wausau, Wisconsin. "Clients are not really understanding these things and they get sold these products. They're just inappropriate."

Variable annuities are also an estate-planning nightmare. Unlike stocks and mutual funds, annuities do not "step-up" in tax basis at death. That means when you die, heirs not only inherit your annuity, but they also gain all of the tax liability that the annuity deferred for years. For instance, if your $50,000 annuity grows to $150,000 when you die, your heirs will have to pay income taxes on the $100,000 in gains. If you would have invested in a mutual fund, all the gains would be passed on tax-free and heirs would only have to pay taxes on earnings made beyond the $150,000 if they chose to hold onto the investment.

"You can't screw up an estate any better than by filling it with annuities," says John Henry McDonald, a financial planner in Austin, Texas.

David Franecki covers Mutual Funds for the Dow Jones Newswires.

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