WealthManagement Magazine

Annuities or No?

The Taxpayer Relief Act of 1997, approved last August, didn't specifically mention variable annuities. But by cutting capital gains rates, it gives unsheltered alternatives a more level playing field. And the Roth IRA likely will prove a more popular destination for at least some investor dollars.Variable annuities certainly won't become extinct. If anything, sales might increase if the new legislation

The Taxpayer Relief Act of 1997, approved last August, didn't specifically mention variable annuities. But by cutting capital gains rates, it gives unsheltered alternatives a more level playing field. And the Roth IRA likely will prove a more popular destination for at least some investor dollars.

Variable annuities certainly won't become extinct. If anything, sales might increase if the new legislation raises the public's awareness of tax-deferral--and if vendors respond with improved products.

Some are. Just three weeks after the tax law was approved in August, Fidelity Investments' insurance arm reduced the annuity charges on its Retirement Reserves product to 80 basis points from 100, taking the rare step of cutting charges for all customers, not just new investors. Fidelity also boosted the number of funds in its annuity lineup to 28 from 13.

"Lowering the fee of our deferred variable annuity is especially timely given the recent reduction in the capital gains tax," says Rod Rohda, CEO of Fidelity Investments Life Insurance Co.

Still, variable annuities come with several disadvantages:

* Ongoing expenses run about 2.1% a year, versus 1.4% on average for stock mutual funds, according to Morningstar. Surrender charges also might come into play.

* Money pulled out of variable annuities is taxed as ordinary income--as high as 39.6%. This is a drawback that traditional IRAs also share, although not the new Roth IRAs, which allow for tax-free distributions. Profits on unsheltered individual stocks and mutual funds can qualify for the new, lower 20% capital gains taxes on positions held at least 18 months.

* Annuities and other qualified retirement accounts offer no step up in cost basis at death. For this reason, clients who are worried about death and income taxes might be better off owning low-dividend stocks or tax-efficient index funds.

A study by T. Rowe Price Associates, which markets both no-load mutual funds and variable annuities, compared the impact of investing in an equity income mutual fund held in a taxable account against a variable annuity. The analysis assumed a pre-tax return of 9% for each investment, along with a 28% income tax rate, a 20% capital gains levy and annuity-related insurance costs of just 55 basis points--well below the industry norm. The study looked at several scenarios, including the case of a 45-year-old investor planning to retire at age 65 and withdraw the cash over 20 years.

In that case, the annuity generated a higher after-tax return only after 18 years of retirement, when the investor would be 83 years old. The break-even point would be even longer for higher-cost products.

"If you're working with average-cost variable annuities, they hardly ever work out," says Steve Norwitz, a T. Rowe Price spokesperson.

But Norwitz cautions investors not to let tax angles dominate their annuity decisions, since tax rates could change in the future. Investors also need to weigh other annuity advantages, such as guaranteed income for life and the death benefit, he says.

Marcy Supovitz, vice president of retirement plans for Pioneer Mutual Funds in Boston, labels several criticisms of variable annuities as myths, such as the notion that investors pay a 39.6% tax rate. "The majority of variable annuity owners are retired, and most retired people have no earned income at all." Supovitz quotes a 1996 Gallup Organization study indicating that most annuity investors had yearly incomes below $75,000, and says a more appropriate marginal rate for retired investors would be 20%, the same as for capital gains.

Joel Kesner, a senior vice president and director of annuities for Prudential Investments in Newark, N.J., views the lack of an investment ceiling on annuities as a key selling point. Although he agrees that investors generally should first take advantage of IRAs and 401(k)s, many people can afford to sock away additional cash.

"These people may need a supplemental savings program, for which a variable annuity makes sense," he says.

Some also like the protection from outliving their assets they get by annuitizing or receiving a steady payment stream, Kesner adds. And the death benefit on variable annuities can be a big plus--ensuring that heirs will at least recoup principal. This allows older investors to take more risks than they might otherwise, possibly mitigating the lack of stepped-up cost basis.

"Guaranteed death benefits are a way to invest in the stock market without passing investment mistakes to your beneficiaries," Kesner says.

The Taxpayer Relief Act of 1997 hasn't hurt variable annuities, according to a recent Price Waterhouse study commissioned by the National Association for Variable Annuities (NAVA).

"Variable annuities remain attractive investments for long-term savers relative to mutual funds," says the study.

Some critics disagree. "The report makes some dubious assumptions," says Patrick Reinkemeyer, an annuity expert at Morningstar. And a study by T. Rowe Price concludes that the higher costs of annuities rarely offset the benefits of their tax-deferred growth.

Critics raise the following objections to the Price Waterhouse study:

* The report's base assumption is that investors are in the 28% tax bracket during their working years and fall into the 15% bracket in retirement. A drop like this is unlikely, say the critics.

* The study presumed variable annuity investors are patient enough to avoid surrender charges and the 10% tax penalty, while benefiting from long-term deferral. But fund investors were assumed to be more fickle, switching 20% of their holdings each year and triggering taxes along the way.

* The study used performance figures from 1987 through 1996, an unusually robust period. "High returns negate much of the impact of fees," says Reinkemeyer.

* The study compared mutual funds to annuities assuming investors draw down their accounts. But if the owner dies first, straight mutual funds would benefit because heirs would get a stepped-up cost basis. This aspect was ignored by the NAVA/Price Waterhouse study.

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