Annuity objectives vary wildly

Your Money

December 17, 2006|By Humberto Cruz | Humberto Cruz,Tribune Media Services

I am being two-faced about annuities, readers tell me. One day, I am in favor of them, and the next day I am against. Where do I really stand?

My unequivocal response: It depends because different types of annuities have different characteristics. While I strive to distinguish between the many types, it is obvious the distinctions need to be made clearer.

"Any statement that fails to distinguish between the different types of annuities is nonsense," said John Olsen, a financial consultant and estate planner in St. Louis County, Mo.

Here is one such statement a reader found in another publication: "Have you ever heard of an annuity? They are very expensive and don't do much for you at retirement, but they are still selling like mad these days. Why? Salespeople are working overtime pitching them to you and me."

Presumably, this writer was referring to deferred variable annuities, which are designed to accumulate funds tax-deferred for retirement in mutual fund-like "subaccounts" with the option of eventually "annuitizing," or turning the accumulated value into a lifetime income stream. That income stream would be based on minimum guaranteed payout factors (at least so much for every dollar of the account value), regardless of future changes in life expectancies or interest rates.

While I also have come down on deferred variable annuities with high expenses and lengthy surrender charges (typically, those promoted by commissioned sales representatives because annuity charges are a source of commissions), such condemnation is not always valid. And it is downright false when referring to immediate annuities, which are not about accumulating funds but about paying an income for life in exchange for a lump-sum premium.

"They are very different beasts with very different objectives," Olsen said.

And then, to confuse matters more, we have other annuity types, including (but not limited to) fixed deferred annuities, which pay a set rate of interest, and equity-indexed annuities that base the interest they pay on the return of a stock index.

Also, many deferred variable annuities offer "living benefits" that, for an additional continuing fee, typically guarantee a present or future minimum income payment (and sometimes minimum account value) regardless of investment performance.

How to make sense of all this? Olsen, a veteran of more than 30 years in the business, wrote a lengthy article on the subject for this month's issue of the trade publication Journal of Financial Service Professionals. Reading it from a consumer perspective, I discussed with him essential concepts potential annuity buyers should grasp:

Ultimately, all annuities are, in varying degrees, part investment and part insurance, and you need to know what you are paying for and whether the cost is worth it to you.

In a deferred variable annuity, the insurance part guarantees the minimum annuitization payout factors and, in most cases, a minimum death benefit to your beneficiary if you die before you annuitize, regardless of how your investments perform.

If these features are important to you, their cost should not be considered a "drag" on investment performance, as critics of deferred variable annuities argue. Rather, they are the price of insurance, "which is not to say it may not be overpriced," Olsen said.

(I would add that often this insurance cost is inflated by hidden commissions and exceeds the investment cost of managing the annuity subaccounts.)

But if your goal is purely accumulation of capital, with no concern for assuring a minimum income later on or for a guaranteed minimum death benefit, a deferred variable annuity may not be appropriate for you, even with the tax deferral. The typical annual insurance charge, from 1.2 percent to 1.4 percent of assets, represents "a significant amount to be paying each year for benefits one does not particularly want," Olsen said.

As for living benefits available for an additional fee, "whether the benefits conferred by these provisions are worth the price charged is surely a matter for individual decision," Olsen said, because the fee reduces your potential return in exchange for the minimum income or account value guarantee.

Tax deferral, a benefit promoted by sellers of deferred variable annuities, does not always outweigh the drawbacks. All gains on deferred annuities are taxed as ordinary income when withdrawn rather than at the lower rates for long-term capital gains. Heirs must pay taxes on gains. And a 10 percent tax penalty generally applies on withdrawals before age 59 1/2 .

In general, the higher your current (and especially your future) tax bracket and the longer you can leave the money invested, the more benefit you'll receive from tax deferral.

Humberto Cruz writes for Tribune Media Services.

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