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Are annuities for you?
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October 15, 1999: 2:45 p.m. ET
A complicated investment is gaining some popularity among baby boomers
By Staff Writer Martine Costello
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NEW YORK (CNNfn) - Annuity. One small word that has triggered a fierce debate among some mutual-fund experts -- and befuddled the most well-informed small investor.
Regardless of whether you think annuities are unnecessary or too complicated, more fund companies are selling them as aging baby boomers worry about retirement.
The trick first is figuring out if an annuity fits into your portfolio and then choosing the right one for your needs. You also need to weigh many pros and cons.
"What's looking baby boomers straight in the eye is retirement," said Farrell Dolan, senior vice president of insurance and annuities at Fidelity Investments. "They're asking, 'Will I have enough to retire?' "
Some definitions to get started
An annuity is essentially an insurance contract. You enter into the contract with an insurance company (fund families like Fidelity have insurance businesses these days) where a chunk of your money is invested and you receive guaranteed payments.
Other terms -- such as when you start getting the payments, how much you get, how long the payments continue and where the money gets invested -- depend on how you set them up. Some also have so-called death benefits, meaning the cash keeps coming to your survivors after you die.
One of the biggest advantages is that annuities aren't taxed until you start withdrawing. But you'll pay income tax rates of up to 39.6 percent on your earnings when you withdraw it, instead of the lower 20 percent rate on capital gains for other investments.
Annuities can be deferred (meaning you wait for the income and let the money grow) or immediate (meaning the payments start right away).
They can be fixed (meaning you get a specific rate on your money) or variable (meaning market conditions will affect the amount you get). Fixed annuities are safer but pay lower interest, more like a bank CD. Variable annuities are more risky but the returns can be much higher (or much lower).
With variable annuities, you can pick from a selection of mutual funds or specially designed investment portfolios. You can change your investments without any tax penalties.
But annuities aren't the cheapest investment in the world. You'll pay a conventional investment management charge of 0.5 percent to 1 percent a year, plus an annuity fee (called a mortality and expense fee) of 1 to 1.5 percent a year, according to the National Association of Variable Annuities, a Washington trade group.
You also may pay a "surrender charge" of up to 7 percent if you withdraw early. The sponsoring company uses the surrender charge to pay a commission of up to 7 percent to dealers who sell annuities.
Investing with an insurance twist
Fidelity considers a deferred variable annuity as a supplement for people who have "maxed out" their 401(k) and IRA plans and have more money they would like to set aside for retirement, Dolan said. Other people choose an annuity if they get money from an inheritance or the sale of an asset, he said.
Fidelity's deferred variable annuity offers 28 investment portfolios, with an annuity fee of 0.80 percent and an average investment management fee of 0.62 percent. The company recently abolished the surrender charge that was 5 percent in year one; 4 percent in year two, and so on down to zero in the sixth year.
The investments range from a technology and communications fund, up 55.92 percent year-to-date as of Aug. 31, to an overseas fund, up 12.19 percent in the same time. The options include funds by Morgan Stanley Dean Witter, PBHG Funds, Strong Funds and Warburg Pincus Funds.
"You get tax-deferred growth and investment control," Dolan said. And unlike an IRA, where you have to start withdrawing at age 70-1/2, you don't have to touch the annuity until you're 85, he said.
Another option, called an immediate annuity, is for people who have just retired who want to roll over a 401(k) or IRA and build an income plan, Dolan said. The annuity will generate monthly payments for as long as they want.
"Only two things guarantee lifetime income -- a pension plan and Social Security," Dolan said. "This is the only other way to generate income that is guaranteed for life."
A hard contract to break
At Charles Schwab & Co., about 70 to 80 percent of its annuity business involves exchanges from other plans, said Barry Streit, national sales director for insurance and annuities.
"If you already have an annuity you don't have much choice," Streit said. If you dump it before age 59-1/2, you could face a 10 percent IRS penalty on your gains and pay income tax rates on the full amount. The best option is to roll it into a better annuity.
Schwab's annuity offers 28 mutual funds from 16 fund families, including Alger, Dreyfus, Invesco, Janus, Berger and Safeco, Streit said. The annuity fee is 0.85 percent and the investment management fee is ranges from 0.28 percent for an S&P 500 index fund to 1.5 percent for Baron Capital Asset Fund. There is no surrender charge.
"A lot of people thought we were crazy for getting into the annuity business," Streit said. "What we tried to do is pull out all the things in a variable annuity that people don't like. …They come to us for more choices."
Taking payments
Streit said there are two main ways to start pulling money out of an annuity. The first is to "annuitize" the money, meaning you give it to the insurance company to administer regular payments. Once you do this, you give up flexibility and you won't have access to the principal. But the advantage is each payment is a mixture of principal and interest, so you're taxed on a much smaller piece.
The second way is through withdrawals whenever you want. The advantage is you keep flexibility and your money stays invested. But the disadvantage is every dollar of gain you take out is taxed at income rates of up to 39.6 percent.
"When you read about the debates, and people who talk in absolutes that annuities are terrible or the greatest thing, they're really neither," Streit said. "There's no such thing as an all-bad, or all-good, investment. You have to look at your overall investing strategy."
A fiery debate
Yet critics abound. Frank Armstrong, president of Managed Account Services Inc., a certified financial planner and author, said he doesn't like anything with the word "annuity" in it.
"They're meant for half of one percent of the people they're sold to," Armstrong said. "I can't imagine who would need to invest in them."
The only case where he could see it making a little sense (and he never recommends them) is in a place like Florida, where an annuity is creditor-proof. For a doctor who might be worried about malpractice suits, for example, an annuity would be out of reach of any judgments.
Or, if a parent had a son who was a drug abuser, an annuity might be a good idea to create regular income without the risk that the child will fritter the money away.
"Why not just walk over to Vanguard and buy the S&P 500 index fund?" Armstrong said. You'll pay capital gains taxes instead of higher income taxes, and there's no penalty for early withdrawal. Vanguard also has some of the lowest fund fees in industry.
Armstrong thinks that many investment advisers recommend annuities because of the high commissions. Why would a dealer recommend a load mutual fund, with a 1 percent commission, when he could get up to 7 percent with an annuity?
"The commissions taint the whole process," Armstrong said.
"Of course he's going to tell you about all the great benefits," Armstrong said. "He's going to stand on the table and dance."
A variable annuity may offer a regular check, but the amount you get will depend on what happens on Wall Street, Armstrong said.
"You'll get a check," Armstrong said. "But it might be six cents."
Plus, there are serious potential tax pitfalls besides having to pay income tax rates on earnings instead of capital gains, Armstrong said. For example, by law 100 percent of your first withdrawal is taxed until you start hitting principal, he said.
And, if you die, the capital gains aren't "forgiven," as with other investments, so your heirs will have to pay income taxes on the money.
"It is complicated," Armstrong said. "That's why people get taken advantage of. …What happens is, predictably, they get screwed."
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