Annuities Provide Security and Income

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Tom Woodruff

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xperts declared it the Tax Annuity Death Act of 1997. When President Clinton signed this tax reform package with its array of tax-favored investments and lower capital gains taxes, tax experts said one of the investment arena's 1990 darlings - variable annuities - had lost its luster.

For the typical investor, the experts are right. But for every rule, there are exceptions.

For years, financial planners and advisers, economists, mutual fund and insurance company sales representatives have argued about the value of tax-deferred annuities vs. taxable investing. The issue revolves around whether you end up with a higher after-tax return from a tax-deferred annuity.

Annuities are, after all, a type of "insurance," in that an insurance policy is wrapped around the investment portfolio. It's very loose terminology, since the only thing the insurance promises is that if you die during a time when your investment portfolio is getting hammered by a fickle stock market, it guarantees your heirs a return on your initial investment. In return, you pay higher fees for this so-called insurance but get a tax savings on the front end.

So the debate has been two-fold: Do the tax benefits outweigh the additional fees and restrictions normally associated with tax-deferred annuities? Or is it more efficient to invest part of your portfolio in taxable investments and be subject to capital gains when they are liquidated?

Sales of annuities have become very important for both insurance companies and mutual fund companies. In 1996, annual sales of variable annuities (including their fixed accounts) soared to a record $73.8 billion. According to Variable Annuity Research Group (VARDS), this represents a 44 percent increase over the year before and more than four times the volume of five years ago. A significant portion of these sales, however, included transfers between annuity contracts of competitors, a form of churning among commissioned agents. For example, in 1995, "redemptions" of variable annuity contracts totaled more than $20.4 billion, much of which included mere transfers between contracts.

By the end of 1996, total variable annuity contract assets exceeded $500 billion. Prior to passage of the Taxpayer Relief Act of 1997, the annuity business looked rosy. After release of the 1996 sales figures, VARDS publisher Rick Carey proclaimed: "Until a prolonged market decline occurs, both the market and its asset levels will continue to set records. When one is in uncharted waters, the element of surprise is the only thing you can count on."

The new tax package, however, has reduced that element of surprise and the industry is now scrambling to adjust its products and marketing strategies.

So who, if anybody, should consider tax-deferred annuities in light of the new tax law? Given that annuities carry a fee structure much higher than ordinary mutual funds, the pool of potential buyers is much smaller.

While funds invested in annuities build up tax-free, they are taxed at ordinary income tax rates when they are withdrawn from the annuity contracts, regardless of the type of asset in the contract.

The new capital gains rules lower the maximum tax on qualifying assets to 20 percent on those held for more than 18 months. In the year 2002, this rate drops to 18 percent.

For investors in the top tax bracket, the difference between paying 18 percent in taxes or 39.6 percent can mean that tax-deferred annuities are no longer a good deal or that they should reconsider which assets are included in the annuity vs. taxable investments. But the death of annuities drum roll may be premature. There will remain a group of investors who for very sound and strategic purposes will continue to use these investment vehicles.

Here are my top five reasons for investing in annuities:

1. You have already maximized your retirement savings in an employer-sponsored or other retirement savings plan

It should be a no-brainer that tax-deferred annuities, where you invest after-tax dollars, should only be considered after you have maximized your pension and retirement savings investments. Once that's done, however, annuities offer another logical way to sock-away tax-deferred cash.

2. You want to have taxable bonds and other highly-taxed investments in your long-term investment portfolio

A study by two Stanford University economists shows that by putting dividend-paying stocks and bonds or other investments vulnerable to higher taxes in a tax-deferred vehicle, investors can realize substantial savings.

3. You want a guaranteed income stream at a specific point in the future

The real future for annuities, and variable annuities in particular, may be as income annuities rather than accumulating annuities. Traditional pension plans that offer guaranteed yearly incomes are in a free-fall. Most employers have switched to 401(k) plans or Keoghs that put workers in charge of their own investment destinies, but with no income guarantees. With the aging of baby boomers, the declining role of pension plans and the accompanying financial woes of Social Security, we desperately need a financial product that guarantees us a lifetime income with some prospect of inflation protection. Variable income annuities just might be the candidate for the job

4. You like to actively manage and re-allocate your portfolio

If you like to actively manage your portfolio rather than merely buy and hold, tax-deferred annuities offer an advantage. You can reallocate among all of the funds within a contract and not create a taxable event. When you normally invest after-tax dollars in mutual funds and want to rebalance your portfolio by, for example, transferring funds from your growth fund to a bond fund, you incur taxes on the gain in the growth fund.

5. You have found an annuity contract with reduced fees

It's a cinch that fees on variable annuities will drop in the wake of the tax act. A few mutual fund companies already offer no-load, low-fee variable annuities that they sell directly to the public without the use of commissioned brokers.

Two companies, T. Rowe Price and The Vanguard Group, stand out in this group. Both companies run their variable annuity programs as part of their broader retirement planning services. They have managed to attract customers fleeing the high fees of other tax-deferred annuities and referrals from fee-for-service financial planners looking for good deals for their clients.

Currently, though, T. Rowe Price and The Vanguard Group are the exceptions in the high-fee, tax-deferred annuity business. This may soon be changing. The tax relief act, with its new individual retirement account options and, particularly, the lower capital gains tax rates will put pressure on the mutual fund and insurance companies to lower their mortality and risk expense fees. This is particularly true since high-income investors, in the 31 percent and 39.6 percent tax brackets, have been major targets for tax-deferred annuity sales efforts. For them, tax-deferred annuities may not be as attractive as they used to be, depending on the types of investments in the annuity contracts.

Remember that high fees can eat into whatever tax advantage you may be receiving. In effect, higher fees lengthen the time that you must hold your annuity to receive the benefit of tax deferral.

Mutual fund giant Fidelity is trying to catch up by announcing that it will lower its mortality and risk expense fees from 1 percent to 0.8 percent in the next few months. Expect to see others follow.

Beyond the top five reasons mentioned above, annuities could also be attractive to investors who want to leave much of their estate to a charity but need a yearly income in the interim. A charitable annuity could be the answer for these investors, although trusts and other investment vehicles offer the same possibilities. By creating a charitable annuity, investors could realize a tax windfall for themselves by making a "donation" to a qualified charity but could also continue to receive yearly payments until their deaths.

And for people who are investing for the long term and do not need access to their funds, annuities are an option. Remember that early withdrawal involves both regular taxation and penalties. And, don't forget those surrender charges that usually apply in the early years after an investment is made.

The point is that the last rites that investment experts have performed over variable annuities may be - and probably are - premature.

Annuities continue to offer a true option for many investors even in light of the tax law changes. There is no question that the attractiveness of these tax-deferred investments has been tarnished. For typical small investors, variable annuities should not be considered until they have their retirement plans well under control.

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How to Choose Investments for Income
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			Annuities Provide Security and Income Tom Woodruff Decision Center

	.......................................... WEB LINK Ask the Experts .......................................... SIDEBAR Get the Best Tax Advantage From Your Variable Annuities		xperts declared it the Tax Annuity Death Act of 1997. When President Clinton signed this tax reform package with its array of tax-favored investments and lower capital gains taxes, tax experts said one of the investment arena's 1990 darlings - variable annuities - had lost its luster. For the typical investor, the experts are right. But for every rule, there are exceptions. The controversy For years, financial planners and advisers, economists, mutual fund and insurance company sales representatives have argued about the value of tax-deferred annuities vs. taxable investing. The issue revolves around whether you end up with a higher after-tax return from a tax-deferred annuity. Annuities are, after all, a type of "insurance," in that an insurance policy is wrapped around the investment portfolio. It's very loose terminology, since the only thing the insurance promises is that if you die during a time when your investment portfolio is getting hammered by a fickle stock market, it guarantees your heirs a return on your initial investment. In return, you pay higher fees for this so-called insurance but get a tax savings on the front end. So the debate has been two-fold: Do the tax benefits outweigh the additional fees and restrictions normally associated with tax-deferred annuities? Or is it more efficient to invest part of your portfolio in taxable investments and be subject to capital gains when they are liquidated? Annuities are big business Sales of annuities have become very important for both insurance companies and mutual fund companies. In 1996, annual sales of variable annuities (including their fixed accounts) soared to a record $73.8 billion. According to Variable Annuity Research Group (VARDS), this represents a 44 percent increase over the year before and more than four times the volume of five years ago. A significant portion of these sales, however, included transfers between annuity contracts of competitors, a form of churning among commissioned agents. For example, in 1995, "redemptions" of variable annuity contracts totaled more than $20.4 billion, much of which included mere transfers between contracts. By the end of 1996, total variable annuity contract assets exceeded $500 billion. Prior to passage of the Taxpayer Relief Act of 1997, the annuity business looked rosy. After release of the 1996 sales figures, VARDS publisher Rick Carey proclaimed: "Until a prolonged market decline occurs, both the market and its asset levels will continue to set records. When one is in uncharted waters, the element of surprise is the only thing you can count on." The new tax package, however, has reduced that element of surprise and the industry is now scrambling to adjust its products and marketing strategies. Who should invest in annuities? So who, if anybody, should consider tax-deferred annuities in light of the new tax law? Given that annuities carry a fee structure much higher than ordinary mutual funds, the pool of potential buyers is much smaller. While funds invested in annuities build up tax-free, they are taxed at ordinary income tax rates when they are withdrawn from the annuity contracts, regardless of the type of asset in the contract. The new capital gains rules lower the maximum tax on qualifying assets to 20 percent on those held for more than 18 months. In the year 2002, this rate drops to 18 percent. For investors in the top tax bracket, the difference between paying 18 percent in taxes or 39.6 percent can mean that tax-deferred annuities are no longer a good deal or that they should reconsider which assets are included in the annuity vs. taxable investments. But the death of annuities drum roll may be premature. There will remain a group of investors who for very sound and strategic purposes will continue to use these investment vehicles. Here are my top five reasons for investing in annuities: 1. You have already maximized your retirement savings in an employer-sponsored or other retirement savings plan It should be a no-brainer that tax-deferred annuities, where you invest after-tax dollars, should only be considered after you have maximized your pension and retirement savings investments. Once that's done, however, annuities offer another logical way to sock-away tax-deferred cash. 2. You want to have taxable bonds and other highly-taxed investments in your long-term investment portfolio A study by two Stanford University economists shows that by putting dividend-paying stocks and bonds or other investments vulnerable to higher taxes in a tax-deferred vehicle, investors can realize substantial savings. 3. You want a guaranteed income stream at a specific point in the future The real future for annuities, and variable annuities in particular, may be as income annuities rather than accumulating annuities. Traditional pension plans that offer guaranteed yearly incomes are in a free-fall. Most employers have switched to 401(k) plans or Keoghs that put workers in charge of their own investment destinies, but with no income guarantees. With the aging of baby boomers, the declining role of pension plans and the accompanying financial woes of Social Security, we desperately need a financial product that guarantees us a lifetime income with some prospect of inflation protection. Variable income annuities just might be the candidate for the job . 4. You like to actively manage and re-allocate your portfolio If you like to actively manage your portfolio rather than merely buy and hold, tax-deferred annuities offer an advantage. You can reallocate among all of the funds within a contract and not create a taxable event. When you normally invest after-tax dollars in mutual funds and want to rebalance your portfolio by, for example, transferring funds from your growth fund to a bond fund, you incur taxes on the gain in the growth fund. 5. You have found an annuity contract with reduced fees It's a cinch that fees on variable annuities will drop in the wake of the tax act. A few mutual fund companies already offer no-load, low-fee variable annuities that they sell directly to the public without the use of commissioned brokers. Two companies, T. Rowe Price and The Vanguard Group, stand out in this group. Both companies run their variable annuity programs as part of their broader retirement planning services. They have managed to attract customers fleeing the high fees of other tax-deferred annuities and referrals from fee-for-service financial planners looking for good deals for their clients. Currently, though, T. Rowe Price and The Vanguard Group are the exceptions in the high-fee, tax-deferred annuity business. This may soon be changing. The tax relief act, with its new individual retirement account options and, particularly, the lower capital gains tax rates will put pressure on the mutual fund and insurance companies to lower their mortality and risk expense fees. This is particularly true since high-income investors, in the 31 percent and 39.6 percent tax brackets, have been major targets for tax-deferred annuity sales efforts. For them, tax-deferred annuities may not be as attractive as they used to be, depending on the types of investments in the annuity contracts. Remember that high fees can eat into whatever tax advantage you may be receiving. In effect, higher fees lengthen the time that you must hold your annuity to receive the benefit of tax deferral. Mutual fund giant Fidelity is trying to catch up by announcing that it will lower its mortality and risk expense fees from 1 percent to 0.8 percent in the next few months. Expect to see others follow. Beyond the top five reasons mentioned above, annuities could also be attractive to investors who want to leave much of their estate to a charity but need a yearly income in the interim. A charitable annuity could be the answer for these investors, although trusts and other investment vehicles offer the same possibilities. By creating a charitable annuity, investors could realize a tax windfall for themselves by making a "donation" to a qualified charity but could also continue to receive yearly payments until their deaths. And for people who are investing for the long term and do not need access to their funds, annuities are an option. Remember that early withdrawal involves both regular taxation and penalties. And, don't forget those surrender charges that usually apply in the early years after an investment is made. The point is that the last rites that investment experts have performed over variable annuities may be - and probably are - premature. Annuities continue to offer a true option for many investors even in light of the tax law changes. There is no question that the attractiveness of these tax-deferred investments has been tarnished. For typical small investors, variable annuities should not be considered until they have their retirement plans well under control.
			What type of investments generate income?
			Articles \|

			How to Choose Investments for Income Are Annuities Worth it?

			Next Steps \|

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