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by Elaine E. Bedel, CFP®, AARP, August 27, 2007
There are two main types of annuities: fixed and variable. What's the difference?
Insurance companies that sell variable annuities invest your premiums in mutual fund-like investments. The amount you receive back changes based on how well those investments perform. You usually can choose where you want your money invested from a list of mutual funds the insurance company offers.
Is Investing in a Variable Annuity Right for You?
Variable annuities may sound good, but you need to look behind the promotions to determine whether such an investment is right for you. The older you are, the less likely a variable annuity will be right for you. Before investing in a variable annuity contract, be sure to investigate and understand two very important issues - risk and costs.
High Commissions. The insurance agent, broker, or banker who sells you a variable annuity will generally earn a commission of 6% to 10% on the money you invest. For example, if you invest $100,000 in a variable annuity, the salesperson will get a commission of $6,000 to $10,000. This will reduce your $100,000 before any investment is made. Be sure you know how much commission is deducted from your contribution, so you can compare it with other investment options.
Tax Benefits Now and Then. A big selling point of the variable annuity is that you don't have to pay income tax on any earnings until you withdraw funds or start to receive payments. However, when you start making withdrawals your earnings will be taxed as ordinary income. Depending on your tax bracket at that time this could be between 10% and 35%. You lose the opportunity to pay the lower capital gain or qualified dividend rate of 5% or 15% that you pay on other investment income. So the benefit of income tax being deferred now may be offset by the higher tax rate that you would pay later. You need to determine if the difference in taxes you pay on a variable annuity versus a mutual fund that you invest in directly is important to you.
Guaranteed Principal. Many investors are attracted to the guarantee that the original principal amount will be returned even if the annuity investments have lost value. Unfortunately, with most contracts this guarantee for 100% return of the principal is only available if the owner dies before the end of the contract. If you want this guarantee of the principal, you have to pay an additional annual expense, called the "mortality cost." According to Morningstar, the average annual fee to get this guarantee is 1.35 % of assets.
Negative Impact to Beneficiaries. If your children or grandchildren receive stock or mutual funds as part of their inheritance, they receive a "step up" in the basis of the investment. This means that all capital gain is eliminated for your heirs. An annuity does not receive a "step up" in basis. Instead, your heirs will have to pay ordinary income tax rates on all payouts they receive from your annuity.
Lack of Liquidity & Penalties Imposed. If you withdraw any funds from your variable annuity before you reach age 59½, you will pay IRS a 10% penalty on the taxable portion -- plus the ordinary income tax you owe. And the insurance company penalizes you if you withdraw more than a specific amount (usually 10% of the original principal) during the surrender period. Typically the surrender period is seven years and starts with a 7% surrender charge. This fee goes down by 1% per year until the surrender period is over. It is not common, but there are variable policies that have a 20% penalty for the entire period of 20 years. That is outrageous, as well as being very inappropriate for anyone whose financial needs may change over two decades. It certainly would be unsuitable for the 75 year old person to whom this was presented as an appropriate investment strategy!
Administrative Costs. In addition to the commission, annual investment management costs and the potential penalties, the insurance company also charges administrative fees. These fees can add 1.5% or more to the annual annuity cost.
Absolutely Not Appropriate for an IRA. A variable annuity is not an appropriate investment for an Individual Retirement Account. An IRA allows you to defer all income tax until you withdraw money from the investment. If you invest your IRA funds in a variable annuity, you are putting a deferred tax investment into a deferred tax account. Because you are already getting deferred taxes through your IRA, you do not need the "deferred income" feature of the annuity or want all the expensive annuity costs. You can invest much more effectively in a bond or a stock mutual fund by simply purchasing them directly in your IRA account.
Bottom Line. If you are considering a variable annuity as the right investment for you, take the time to read the annuity contract. There are many options and riders available that can make the investment more attractive but potentially more complex and more expensive. As you do, keep a list of all the current and future expenses. After you have a thorough understanding of the annual costs that will reduce your investment return, ask the salesperson about the commission that will come off the top. Then decide if the risk of fluctuating returns is the right risk for you.
Elaine Bedel, CFP®, is a personal financial planner with over 25 years of providing financial planning and investment management for executives, professionals, and entrepreneurs. She is the President and Owner of Bedel Financial Consulting and has served as Chair of both the Financial Planning Standards Board and Certified Financial Planner Board of Standards.
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