Variable Annuities

When Congress turns to raising taxes, American investors turn to variable annuities.The Tax Reform Act of 1986 that eliminated so many tax-saving opportunities provided the initial stimulus. Last year's reform that boosted the top marginal tax rate gave yet another push.As a result, variable annuities total more than $220 billion in assets, up substantially from a year ago, and momentum is going strong.For those of you who haven't yet caught the fever, a variable annuity is a product offered by insurance companies, brokerage firms and banks that permits you to invest in a wide range of mutual funds and to defer accumulated earnings until you begin to withdraw money.

We have a problem. "I have an annuity purchased for me by an investment broker at my bank," a reader wrote. "I'm having difficulty understanding what this is. He has since left the bank and his successor isn't much help. The money is tied up for four years with a 9 percent early withdrawal penalty." From another reader: "My husband and I are being pressured to buy a variable annuity. I was told we'd never lose our principal, but I am really scared. We have to do this in about two weeks."

THE ELIOT Spitzer prosecution train seems to have hit the law of diminishing returns. It has been more than a month since the New York lawman rocked Wall Street with a major settlement for financial chicanery. Lately he has bullied Maryland's Jos. A. Bank Clothiers Inc. for the way it sells $400 suits and issued press releases with these headlines: "Investigation Reveals Deplorable Plight of Restaurant Bathroom Attendants," "Wedding Photographer to Reimburse Jilted Clients" and "Poacher Pleads Guilty to Timber Theft."

To generate lifetime income in retirement, my goal is to tap our savings and investments as needed without having to rely on insurance company guarantees. If it turns out my wife, Georgina, and I need those guarantees, or if insurance products such as lifetime income annuities become more attractive, we stand ready to change our plan. But, for now, we favor what financial planners call a "systematic withdrawal" strategy, one we intend to personalize rather than rely on rules of thumb.

Amid the explosion in sales of variable annuities, make sure this impressive insurance product doesn't damage your pocketbook.A furtive search for tax-deferral strategies under the Clinton administration, a desire for higher returns and the aging of the Baby Boom generation are responsible for the burst in activity.More than $20 billion in investor money was put in variable annuities in 1992, a 59 percent increase over the prior year, according to the Life Insurance Marketing and Research Association.

VARIABLE ANNUITIES - investments that combine market risk and a life insurance guarantee - are on the hot seat again. The regulatory wave that in recent years has swept over Wall Street analysts and mutual fund market-timers appears to be headed to sales practices and pricing of variable annuities. But this time it will be difficult for ordinary investors to express shock and awe. Few investors knew the extent to which brokerage analysts shilled for favored companies. Fewer still understood how mutual funds were manipulated, at their expense, to profit from discrepancies in prices of underlying securities.

We have a problem. "I have an annuity purchased for me by an investment broker at my bank," a reader wrote. "I'm having difficulty understanding what this is. He has since left the bank and his successor isn't much help. The money is tied up for four years with a 9 percent early withdrawal penalty." From another reader: "My husband and I are being pressured to buy a variable annuity. I was told we'd never lose our principal, but I am really scared. We have to do this in about two weeks."

Decisions, decisions.Variable annuities sold by insurance companies offer investment return, tax deferral of your gains and death benefits in one easy package. But that doesn't make them simple. Average investors must keep in mind that variable annuities are not all alike, that some portfolios can be rather volatile and that one's investment horizon should be long-term.Even within a single insurance firm's variable annuity offerings are a number of stock or fixed-rate choices. Doing homework is crucial.

VARIABLE ANNUITIES became popular by offering tax-deferral on underlying mutual funds. But now that the new tax law is cutting the maximum capital gains tax from 28 percent to 20 percent, many people are asking whether the tax-deferred annuities make sense for them.What exactly is a variable annuity?It is a mutual fund, or funds, inside a tax-deferred insurance wrapper. Investments are made in mutual funds offered by the particular annuity."Annuities still hold attraction," says S&P Outlook, adding, "Although reduction in the top capital gains rate from 28 to 20 percent lessened their appeal, some investors may find them worthwhile."

With the memory of April 15 still fresh, many brokerages, banks and insurance companies are pushing variable annuities -- a complex tax-sheltered combination of insurance policy and mutual fund. With expectations that President Clinton will seek higher income taxes, many taxpayers are becoming more interested in sheltering money.But the complexity of variable annuities -- together with their high expenses and withdrawal costs -- limits their usefulness to fewer people than the sales forces would like.

Most American investors favor what I've long considered a smart long-term strategy, investing in the stocks of companies that consistently increase their dividends. But they do it without much understanding of the benefits, including superior compounded returns over time and a preferential tax rate. That is one finding among many that emerged from a comprehensive survey by Eaton Vance Corp., a Boston-based investment management firm, underscoring a continued and major need for investor education.

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?

The rap against variable annuities is that steep surrender charges can lock you into a bad contract and high annual expenses erode your return. For the most part, I find this criticism valid. But little-known low-cost annuities offer a viable alternative, particularly for do-it-yourself investors. These low-cost annuities are available mostly through major no-load mutual fund firms, including Fidelity, Vanguard and T. Rowe Price, as well as through lower-cost brokers such as TD Waterhouse and Charles Schwab.

Q. Your article about variable annuities with a lifetime income guarantee was interesting. Could you explain in more detail the differences between this benefit and annuitization? A. I wrote about a relatively new lifetime income benefit rider offered by several insurance companies that issue variable annuities. With this optional benefit, which comes at an extra cost, the annuity purchaser can choose to receive a minimum lifetime income regardless of how the annuity investments perform and without having to "annuitize," or give up access to principal.

Trying to fashion a road map for retirement? Good luck with that. Just about every aspect of retirement planning is full of unknowns: Social Security insolvency estimates and reform proposals change constantly, corporate pensions are under stress, and the exact amount of money retirees will need is a moving target. Adding volatility to all three, there is even growing debate on how many retirees will live long enough to have the problem of outliving their assets. Writing in the New England Journal of Medicine's March 17 issue, researchers led by a University of Illinois professor called into question the Social Security Administration's recent life expectancy increase - to the mid-80s - later this century.

THE ELIOT Spitzer prosecution train seems to have hit the law of diminishing returns. It has been more than a month since the New York lawman rocked Wall Street with a major settlement for financial chicanery. Lately he has bullied Maryland's Jos. A. Bank Clothiers Inc. for the way it sells $400 suits and issued press releases with these headlines: "Investigation Reveals Deplorable Plight of Restaurant Bathroom Attendants," "Wedding Photographer to Reimburse Jilted Clients" and "Poacher Pleads Guilty to Timber Theft."

With insurance companies such as First Executive and First Capital going under and holders of their annuities unable to get ++ their money out, you might be a little leery if you get a call from a salesperson offering a variable annuity.But because of the way it is structured, a variable annuity may -- repeat, may -- be safer than a fixed annuity. That does not mean you should rush out and buy one. Variable annuities are as complicated as they sound. But with about $50 billion sold already, someone is buying them.

IAM 60 years old. I invested $80,000 in an American Skandia variable annuity in December 2002. In late January of this year, I received an IRS Form 1099-R that treated this annuity's $1,645 "administration fee" as a taxable event for 2003. How can this be? Administration fees extracted from IRAs and other tax-deferred investments are not treated as taxable income. Why are variable annuities different? And is there any way I can deduct this fee or mitigate its tax consequences? -- W.D., Glastonbury, Conn.

Is it possible to give a regular IRA directly to charity? - J.T., Baltimore No. "You cannot give an IRA directly to charity," said Ed Slott, a certified public accountant and publisher of Ed Slott's IRA Advisor. The only way to make a charitable donation through an individual retirement account is to withdraw money from the account. Withdrawals from regular IRAs, with few exceptions, are taxed as ordinary income, Slott said. Under tax laws, $10,000 withdrawn from an IRA - for people taxed at a rate of 15 percent - would be worth $8,500 after taxes.

IT HAS BEEN a year since New York state Attorney General Eliot Spitzer fired the shot heard 'round the mutual fund world. Though much of the coverage of the anniversary has focused on improvements and changes in the fund industry since the scandals over improper and late trading were uncovered, it's more appropriate for investors to look at what happens next. What fund investors lost during the scandal was not so much money as it was trust. Reform efforts have focused on re-establishing the faith, but there has been no proof that the changes have improved anything yet. Fund firms must now disclose the incentives used to determine manager pay, and whether managers are invested in the funds they run, but the information has no real meaning to a shareholder who has never had it before.