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Annuity confusion
A new broker put my money into a variable annuity, and now I have less than I started with!
September 7, 2004: 6:38 PM EDT
By Walter Updegrave, CNN/Money contributing columnist

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NEW YORK (CNN/Money) - The broker I had been dealing with for many years left his job and his firm introduced me to a new guy who put my IRA money into a variable annuity. It sounded good because I can buy and sell investments within the annuity without triggering taxes, but it was a disaster. After nearly four years, I have less than I started with. When I asked him to take it out, he said I'm in for a 10-year contract. I feel taken -- what should I do?

-- Loren, Riverside, Calif.

I get questions like this about variable annuities -- essentially, an investment that contains mutual fund-like portfolios whose gains aren't taxed until you withdraw your money -- so often that I feel I ought to come up with a name for this syndrome.

Trouble is, I don't know whether to call it "Annuity Confusion," which implies that the investor just didn't understand all the ins and outs of these complex investments before signing up for one, or to call it "Annuity Scam," which suggests that some advisors are simply misleading their clients about what they're getting. Who knows, maybe it's a combination of the two.

When it doesn't make sense

In any case, so that investors like you and thousands of others like you know what you're getting into when a broker, planner, insurance agent or other sales person pitches an annuity for a 401(k) or IRA rollover, I think it's important that I lay out the situation where I believe a variable annuity don't make sense for rollover money, and a situation where they can make sense.

Let's start with the situation where I don't think they make sense.

Let's say you're moving money from the 401(k) plan of a former company, but you're not ready to retire and, indeed, you'll still be accumulating savings over the next 10 years or more to build your retirement nest egg.

Ordinarily in such a case, you would either move the money into the 401(k) plan of your new employer or you would transfer the money into an IRA rollover account at a brokerage or mutual fund firm.

But let's assume that about this time a broker realizes what you're about to do (sometimes I think rollover money throws off a scent like pheromones) and instead suggests moving the money into a variable annuity. Actually, the variable annuity will still be within an IRA account, and it may even go by a name like "IRA annuity."

Usually, the broker bases this recommendation on the fact that annuities allow your investment to grow free of taxes until withdrawal and, as was apparently suggested in your case, you can move your money around from "subaccount" to another (basically, a subaccount is a mutual fund within a variable annuity) without having to pay taxes on any gains.

The broker will probably also note that the annuity has some form of "death benefit," which means your heirs will get either the annuity's account balance or the amount you originally invested, whichever is higher. (There are many variations on the death benefit, but we won't go into them here.)

But why?

For many people, the annuity seems to make a lot of sense, so they follow the broker's recommendation. But I contend that in a case like this they've gained very little if anything at all. Why?

Well, for one thing if you simply roll your money into your employer's 401(k) or into an IRA rollover account, you won't owe any income taxes on the money you're moving.

Second, any gains that your money racks up while its in the 401(k) or IRA rollover escapes income taxes until you begin withdrawing money from the IRA. In short, you've gained nothing extra by going to the annuity.

Ah, but you do have that death benefit. I contend, however, that this isn't worth a whole lot since two things have to happen for you to collect on it: the market has to go down enough to wipe out any gains in your account and you have to die while this is the case. The chances of that aren't impossible. But if you're investing for a long period, they're pretty low.

So what's wrong, you may ask, about taking this protection just in case? Nothing, except that annuities have a whole layer of extra expenses that mutual funds don't have that erodes their return. Those expenses can boost the annual fees for annuities to 2 percent or more.

What's more, most annuities have "surrender charges" that can run as long as 10 years and can dock you in some cases for 10 percent of the amount you withdraw in the early years. (I assume this is what your broker mean by a 10-year contract.)

This means that in order to protect yourself against a low-probability event, you pay higher fees and accumulate a smaller nest egg than you otherwise would. And you incur penalties if you need to withdraw your money during the surrender-charge period.

In short, if you're still in the accumulation stage -- that is, still trying to build the value of that nest egg -- then I don't see much value in moving 401(k) or IRA money into a variable annuity. I think you're better off just going into a new employer's 401(k) or an IRA rollover and getting the tax-shelter there.

Okay, so when would a variable annuity make sense?

Well, let's say that you're planning to retire immediately or within a few years and that you want to begin turning some of your retirement savings into a stream of cash that will support you in retirement.

In that case, an annuity (whether it's variable or a fixed annuity, which works kind of like a CD) can be a good choice because annuities have one feature no other investment has: they can generate a lifetime income.

You invest a certain amount of money in the annuity, and the insurer pays you income that can last the rest of your life no matter how long you live. In this case, you're not using the annuity for tax shelter as much as a retirement income vehicle.

That income stream can be fixed, in which case, you're getting what's known as a "fixed payout" aka "fixed immediate" annuity; or it can be a "variable payout" aka "variable immediate" annuity, in which case the income you get will vary with the performance of the variable annuity's mutual fund-like portfolios.

The variable annuity's payments can go up and down, which makes budgeting tricky. But if those portfolios perform well, the variable annuity's payment can grow substantially over retirement, doubling or more.

In other words, if you're planning to retire soon and you're looking to generate income from a 401(k) or IRA, then a fixed- or variable-payout annuity can be a decent choice.

Even then, you've got to consider a number of factors before investing in an annuity. For example, you don't want to put all your money into an annuity because there are severe restrictions on getting access to your money once you've "annuitized," or turned it into an income stream.

And you want to shop around to find an annuity with reasonable fees, so you get to keep as much income as possible. For more on evaluating what role, if any, annuities might play in your retirement planning, you might check out my new book,"We're Not In Kansas Anymore: Strategies for Retiring Rich In a Totally Changed World," which goes into great detail about the pros and cons of annuities and how to choose one.

What to do?

Finally, let's get back to what you ought to do. If you really feel that you've been "taken," the first thing I'd do is go back to the broker who sold you the annuity and explain exactly why you feel you were misled.

Were the fees and surrender charges not adequately explained? Was the death benefit inaccurately portrayed? Were you not apprised of the investing risks in a variable annuity? Of course, sometimes brokers and planners do take the time to explain the various pros and cons of these complicated investments, but investors tune out any potential bad news. Be sure to be honest in your appraisal of what happened.

If you're certain the broker didn't adequately explain the risks, I'd ask that the broker return my original investment without any penalties.

If that doesn't happen -- and I suspect it won't -- I'd go to the broker's supervisor and make my case. If I didn't get satisfaction at that point, I'd take my case in writing to the regulators, which have been cracking down on variable annuity sales abuses in recent years. In particular, I'd go to the Securities and Exchange Commission, the NASD and my state insurance regulator.

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While your case is being evaluated, make sure your money is invested in a diversified blend of subaccounts that match your tolerance for risk, which is to say forget that scheme of moving your money from one subaccount to another to generate tax-deferred gains.

I hope you sort things out to your satisfaction. But whether you do or not, I at least hope that by bringing your plight to readers you might be able to prevent some other investors from ending up in the same position.


Walter Updegrave is a senior editor at MONEY Magazine and is the author of "We're Not in Kansas Anymore: Strategies for Retiring Rich in a Totally Changed World."  Top of page




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Most stock quote data provided by BATS. Market indices are shown in real time, except for the DJIA, which is delayed by two minutes. All times are ET. Disclaimer.

Morningstar: © 2014 Morningstar, Inc. All Rights Reserved.

Factset: FactSet Research Systems Inc. 2014. All rights reserved.

Chicago Mercantile Association: Certain market data is the property of Chicago Mercantile Exchange Inc. and its licensors. All rights reserved.

Dow Jones: The Dow Jones branded indices are proprietary to and are calculated, distributed and marketed by DJI Opco, a subsidiary of S&P Dow Jones Indices LLC and have been licensed for use to S&P Opco, LLC and CNN. Standard & Poor's and S&P are registered trademarks of Standard & Poor’s Financial Services LLC and Dow Jones is a registered trademark of Dow Jones Trademark Holdings LLC. All content of the Dow Jones branded indices © S&P Dow Jones Indices LLC 2014 and/or its affiliates.