Annuities: When Do They make Sense?

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	When Do Annuities Make Sense? Personal Finance Advisor by OnLine August 12, 1996

As they become more popular, investors need to know what to look for.

Annuities have experienced a resurgence, thanks to variable annuities. The popularity of variable annuity contracts can be traced to investors’ fondness for equity mutual funds and to the ability to defer taxes on payments into annuities.

An annuity, generally, is a contract that promises to pay the owner an amount for a specified period of time, or until death. There are two types of annuities -- fixed and variable.

Fixed annuities are invested in fixed income instruments, such as bonds. The sponsor (an insurance company) guarantees a rate of return for the investor. Purchase payments for fixed annuities are deposited into the sponsor’s general account and subject to the claims of the sponsor’s creditors. A fixed annuity’s guarantees are, therefore, only as good as the credit worthiness of the sponsor.
Variable annuities are invested in equity mutual funds selected by the investor. The sponsor (an insurance company or a bank) does not guarantee a rate of return; rather, the investor’s return depends on the performance of the mutual funds. Variable contract purchase payments are placed in a separate account, which is segregated from the sponsor’s general assets.

"If the risks associated with equity mutual funds are acceptable, variable annuities may be the better alternative. Variable annuities, however, are not for everyone," notes Thomas Myers, senior manager, Financial Counseling Services Group, .

Tax Deferral: Annuities are one of the few tax-sheltered investment products that survived tax reform. Investment earnings from annuity contracts are taxed as ordinary income -- not as capital gains -- when withdrawn. Most annuity withdrawals are made after retirement, when the investor is generally in a lower tax bracket. The tax deferral benefit, therefore, is not as attractive if (1) the investor’s tax bracket is higher when withdrawals are made, or (2) the capital gains tax rate is significantly lower than the ordinary income tax rate.

The ability to invest in equity mutual funds on a tax-deferred basis is an alluring feature of variable annuities. Because stocks generally outperform other investment instruments over the long term, variable annuities’ stock-based investments, coupled with the tax deferral, can result in impressive investment returns.

Unlimited Contributions: Changes in the tax laws reduced the amount that individuals with higher incomes can contribute annually to retirement plans. There are no limits, however, on purchase payments (contributions) for annuity contracts. This feature may be beneficial for investors with annual incomes over $150,000, or those who start saving for retirement later in life.

Withdrawal Options: Annuity distributions may be delayed until age 85, unlike retirement plans, which generally require that distributions begin after age 70½. Individuals can usually choose from several withdrawal options:

Life Annuity: Payments are made for the life of the investor.
Joint and Survivor Life Annuity: Payments are made over the life of 2 individuals.
Life Annuity With Period Certain: Payments are made for life, but if the investor dies before a guaranteed period ends, a beneficiary receives the remaining payments.
Payments of a Fixed Amount: Payments of a set amount are made until the accumulated value is depleted.
Lump Sum: All of contract’s accumulated value is paid in one distribution.

Minimum Death Benefit: Annuity contracts offer a minimum death benefit. If the owner of a variable annuity dies before making any (or all) withdrawals, beneficiaries will receive at least the principal invested (less any loans or prior withdrawals). Under some variable contracts, the guaranteed minimum death benefit is increased periodically (e.g., every 5 years) as the accumulated value of the investment grows.

Costs: A primary disadvantage of annuity investments is their costs. Individually, annual fees may appear nominal, but collectively they can be over 2% of the value of the investment for variable annuities. The higher fees can significantly reduce the return on a variable annuity contract. The following chart summarizes various fees and other charges that may be associated with an annuity.

Fees/Charges	Description
Administrative	Fee to cover sponsor's costs of issuing contracts, maintaining customer records, and other administrative services.
Management	Investment management fee charged by the underlying equity mutual funds in variable annuities.
Mortality	Payment for minimum death benefit guarantee.
Sales	"Backend" sales or commission charge (generally lowered or waived after a certain number of years).
Surrender	Fee for premature cancellation of the contract (can be up to 10% of the value of the contract).
Tax Penalty	10% IRS penalty on amounts withdrawn before age 59½.

As the chart indicates, hefty surrender fees and tax penalties can make it very expensive to access funds prior to retirement.

Retirement Plan Participation: Financial advisors generally agree that investors should take full advantage of available retirement plans before buying an annuity product. That is, before investing in an annuity, investors should make maximum allowed contributions to 401(k) or 403(b) plans, Keogh plans (for self-employment or consulting income), and Individual Retirement Accounts (even if nondeductible for tax purposes).

These are some thoughts to consider. Your financial advisor can provide more information, and should be consulted before any action is taken.