Some owners of variable annuities made an alarming discovery in the bear market: They could lose money.
The Securities and Exchange Commission received 686 complaints last year about variable annuities, an 83 percent jump since 2000, when the stock market reached its peak.
Most complaints fell into two camps. Some people didn't realize that their money was invested in the stock market until they saw their shrinking accounts, said Susan Wyderko, director of the SEC's Office of Investor Education. Others didn't know that the guarantee of principal kicked in only if they died.
"They didn't understand what they were buying," she said.
Deferred variable annuities aren't simple. They're a marriage of investments and insurance. Often the money is invested in mutual funds, where it can grow tax-deferred until retirement age. Future payments are based on investment performance and can be taken in a lump sum or as an income stream.
If the annuity owner dies before receiving payouts, the beneficiary will receive the principal or the market value of the account, whichever is greater.
In addition to these basics, variable annuities can have lots of bells and whistles.
"They are mind-bogglingly complex but deceptively simple to describe. They are mutual funds with an insurance wrapper," said J.J. MacNab, an insurance analyst and president of Insurance Barometer in Bethesda. "When you look at the nuts and bolts, it's like assembling a car."
For those not mechanically inclined, the National Association of Securities Dealers issued an investor alert last month on what to ask before buying a variable annuity.
At the same time, the NASD announced that it had taken disciplinary action against a Florida brokerage and filed complaints against three brokers in other states, all involving the sale of variable annuities.
The NASD also is concerned about advertisements aimed at brokers suggesting that they target seniors for variable annuity sales, said John Gannon, associate vice president with NASD.
"A deferred variable annuity is a long-term investment" and wouldn't be appropriate for older investors who will need their money in the next six to eight years and have to pay a penalty, or "surrender charge," for early withdrawals, Gannon said.
Many experts advise investors to max out their 401(k) or other tax-deferred retirement plan before buying a variable annuity. A 401(k) gives investors a tax break up front, provides tax-deferred growth and often includes an employer match.
And now there's a new reason to hesitate before committing to a variable annuity: taxes.
Under the new tax law, investments held in taxable accounts gain an edge because the tax rates on dividend income and capital gains are capped at 15 percent. Annuity withdrawals remain taxed as ordinary income, so individuals can be taxed as much as 35 percent on investment gains.
The candidates best-suited to variable annuities are long-term, sophisticated investors in a high tax bracket now who expect to be in a low one later, MacNab said. Even then, they should stick to low-cost annuities that don't carry surrender charges, she advised.
And the best investments to hold in an annuity are those that are tax-inefficient, such as bonds and real estate investment trusts, said Robert Nestor, head of Vanguard Group's annuity and insurance services.
Other factors to consider:
Annuities are not liquid. Investors generally must keep their money in a variable annuity until age 59 1/2 . Early withdrawals trigger a 10 percent penalty, plus income taxes on gains.
Also, many variable annuities assess a surrender charge if investors bail out during the first six to eight years. Typically, the charge is 8 percent the first year, 7 percent the next year and so on until it disappears.
Check out fees. Annual fees for administration, insurance, investment management and special features vary widely. On the lower end is Vanguard's annuity, which charges 0.48 percent to 0.93 percent, depending on funds and insurance features selected. Other companies charge 2 percent or more, experts said.
"People may be paying for bells and whistles they don't need. Do you need long-term health insurance or do you need a principal protected feature?" Gannon said. "If you don't, why are you paying for it?"
Review bonus offers. You may be promised an up-front bonus if you buy an annuity. "Read the small print," MacNab said. The company may fund the bonus by charging higher fees, she said.
Making an exchange. If you're in a high-fee variable annuity and past the stage of surrender charges, it may make sense to switch to a low-cost annuity with no surrender charges, MacNab said.
Make sure the switch is in your best interest, not that of a commission-seeking sales person, experts said. Also, make sure you're not switched to an annuity that starts the time clock again on surrender charges, they said.
One deferral is enough. Putting an annuity into an individual retirement account doesn't make sense, experts said.
"Putting an annuity in an IRA is like staying indoors and putting on a raincoat and an umbrella to keep from getting wet," said Christopher Brown, a financial planner in Gaithersburg. "You already have the tax-deferral vehicle, which is the IRA."
