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Low-cost annuities are quiet money-savers

By HUMBERTO CRUZ
Tribune Media Services columnist

Posted October 30, 2005

The rap against variable annuities is that steep surrender charges can lock you into a bad contract and high annual expenses erode your return.

For the most part, I find this criticism valid. But little-known low-cost annuities offer a viable alternative, particularly for do-it-yourself investors.

These low-cost annuities are available mostly through major no-load mutual fund firms, including Fidelity, Vanguard and T. Rowe Price, as well as through lower-cost brokers such as TD Waterhouse and Charles Schwab. There are no sales or surrender charges, and annual expenses are below average, sometimes considerably.

And yet (with the exception of the "ultra low-cost" Fidelity Personal Retirement Annuity launched by Fidelity Investments Life Insurance Co. on Aug. 15) these annuities are seldom advertised.

Look at the numbers. According to recent figures, investors had $885 billion invested in Vanguard mutual funds and exchange-traded funds, compared with $9 billion in the Vanguard Variable Annuity, available through Peoples Benefit Life Insurance Co. since May 1991. At T. Rowe Price, investors had $163 billion invested in the firm's mutual funds but only $274 million in the T. Rowe Price No-Load Variable Annuity, first issued by Security Benefit Life Insurance Co. in April 1995.

Overall, of the nearly $130 billion in variable annuities sold in the United States last year, a mere 1 percent were by direct response from investors. The rest, typically carrying much higher expenses, were sold by insurance agents, brokers and banks, according to the trade group the National Association for Variable Annuities.

But then, nobody is pushing these low-cost annuities. Even the firms that offer them encourage investors first to determine whether an annuity is suitable for them. After all, these companies have no particular incentive to sell you a variable annuity if they can get you to invest in their mutual funds or another one of their products.

Low-cost variable annuities can be appropriate for younger people saving for retirement who have contributed the maximum to other tax-deferred options such as individual retirement accounts and 401(k) plans and who have the time for the tax-deferred compounding to overcome the higher annuity costs and taxes on withdrawals.

"The length of time you hold the investment is a key," said Stuart Ritter, a certified financial planner with T. Rowe Price. For variable annuities to work best, "we are talking decades," he said.

In addition, low-cost variable annuities can make sense for investors who want to get out of high-cost products, particularly if they are past the surrender charge period.

"A lot of people have bought high-cost annuities and they need to know there is a place they can go," said Ellen Rinaldi, a Vanguard principal. By doing a "1035 exchange," you can move money from one annuity to another without tax consequences.

To refresh everybody's memory, a variable annuity is a contract with an insurance company that allows tax-deferred investments in "sub-accounts" similar to mutual funds. But as insurance products, variable annuities levy additional charges.

The most significant is the annual "mortality and expense risk" charge, which often runs at 1.25 percent or more of the account value each year. Among other things, this "M and E" charge pays for guaranteed payment rates and for a death benefit. The death benefit guarantees that if you die before starting to take money out of the annuity, your beneficiary will get back at least what you put in (the basic death benefit) or even a higher amount (an enhanced, or stepped-up, death benefit).

Whether the death benefit is worth the cost is a complex topic I will discuss another time. The point is that with almost all variable annuities you have to pay for it whether you want it or not. But the new low-cost Fidelity annuity eliminates the death benefit (beneficiaries get whatever the account value is) and charges only 0.25 percent in annual annuity costs (0.05 percent for administration and 0.20 percent "M and E"), compared to the 1.41 percent total industry average.

"We stripped out all the bells and whistles," said Jeff Carney, president of Fidelity Personal Investments. "Sometimes investors pay for features they don't really need."

With Vanguard, you can choose a basic death benefit (0.35 percent annual expenses), a stepped-up benefit (0.42 percent) or just the account value (0.30 percent). The T. Rowe Price annuity, which comes with a built-in stepped-up death benefit in all states but Florida, charges 0.55 percent in annual expenses.

There is more than cost to consider, of course. With the Fidelity, Vanguard and T. Rowe Price annuities, investment choices are limited to funds from among those offered by each firm.