Variable Annuities

First, it sounds like you are mixing up two different kinds of annuities. The ones with ratches and resets are [equity-] indexed annuites EIA and considered different than general variable annuities VA.

Avoid the kind salesmen push, because they are likely to have high commissions and penalties. Buying them inside a tax account (401k) is silly, because insurance products are already tax deferred. The conventional wisdom is a little off. It used to be VAs had large management fees 3-4% (this includes the mandatory insurance fee which gives it tax status). Plus they used to have early withdrawal penalties up to 10%. Newer VAs sold by Fidelity, Vangauard, etc. have fees as low as .32% and no penalty. They contain Fidelity's regular mutual funds, but arent as liquid. Fidelity only allows a limited number of trades a year and dont execute immediately. Not for market timers. I havent heard of cheap EIAs yet. If they have a charge larger than

0.25% and any penalty, stay away.

Although annuities defer taxes, you pay earned income tax rates, e.g.

15, 25, 28, 33% on the withdrawals depending on your tax brackets. A capital investment like stock is taxed at 10 or 15% held longer than a year. (These rates yo-yo depending on presidential tinkering.)

VA downside;

1) A mortality charge that is often 10x the true cost. (500K of 10 yr term insurance might cost you $13-1400/yr. This is .28%. But consider, even after a bad crash, the stock market will not go to zero. You can safely insure yourself by having term insurance for 1/3 to 1/2 the value of your portfolio. And when you die, it will pay off even if the market is up). Check the mortality charge on the annuity you are looking at. 2) Most annuities have surrender fees, starting at 10% the first year, declining over a ten year period. 3) The initial fee to the seller is likely near 5%. 4) The gains on the annuity do not get stepped up basis on your death, it's just like inheriting an IRA. 5) The investment choices within the annuity are limited. 6) The gains at withdrawal are taxed at ordinary income rates, while an investment in a taxable account are taxed at favorable dividend and long term cap gain rates. 7) Even if you choose a no-surrender fee, low cost, fund (say one offered by Fidelity), the effect of (6) above negates any tax deferral advantage over time. 8) even after the surrender fee has passed, there are pre-62 penalties for early withdrawal. (This wouldn't apply to you, as you'd be 62, I include for sake of completeness.)

I'm still compiling my list, for sake of an FAQ I hope to author, but this is it so far. See

for further comment. And google ["scott burns" annuity] for his take on this topic. VA upside;

1) The seller receives a huge first year commission, and good annual commissions for the life of the product. (For most VAs)

JOE

An emphatic "do not buy," except maybe when you are well into retirement. I echo Rick's and Joe's comments, with emphasis on income tax rates favoring taxable accounts over VAs. IMO the VA industry has not yet fully adjusted to the reality of the 2003 income tax changes. When you are in retirement, the only VA to consider, as Rick points out, is indeed the type that Vanguard and Fidelity are now offering: no surrender fee, low expense, no death benefit, VAs. My site (cited by Joe) also gives links to three other sites that I thought helpful on this subject.

OUTDATED.

OUTDATED.

GOOD POINT.

JUST LIKE MOST 401KS

TRUE. However if one is investing in ones 30s for income in ones 80s, there arent many stocks that will turn into dogs in the meantime that you'll have to sell early, take gains and pay taxes. Plus gains were taxed same as income until 1978 and from 1986 to 1994 and may again.

See explanation for 6.

A VA or EIA might be viable for a late saver or a high income saver where current deferred amounts are too paltry. I wouldn't put more than a fraction of ones savings solely in one investment vehicle because tax laws and economic conditions change with time, especially over decades. So a VA could be a 20% solution for some people, but not a 50% or 100%. I am very pleased with the tax deferrals in received in one of the these "almost free" VAs in the current four year bull market.

The first question is not "buy or don't buy?" It's "what am I trying to achieve here?" Then and only then, comes "does this instrument help me meet that need or not?" And after that, perhaps, "is there some other way to meet that need? and is this way reasonable and effective (and, maybe without too many downsides)?"

Generally, VAs are used to supplement IRAs when folks have already maxed out the IRAs and are not recommended (responsibly) for use inside an IRA.

Before we even look at the costs of the VA you are considering, it'd help if you told us more about your situation and what you are trying to accomplish and why you think a VA might help you do that.

*potential* (far far from guaranteed!) protection of assets from lawsuits. This may be achieved in other ways, too, however.

Generally not considered as assets when applying for financial aid for college, certainly not on the federal application and possibly not on private applications, too.

Rick, Elle and I exchanged spreadsheets some time back, assuming a .25% cost (as Fidelity has). Over time, that extra cost was enough to negate the gains from tax deferral. Can you provide the assumptions you make when saying that the VA is a solution? If you maintain that the buyer is in this for the long term, then the only deferral is on the reinvested dividends or cap gain distributions, no? If we assume the long term 7% growth, 3% Dividend or near that, the VA buyer is paying .25% for sake of deferring 3%, that kind of looks like an 8% annual cost (.25/3.00), the way I look at it. I am still reviewing prospectuses which include high costs and surrender fees, I hope those are fewer in number as time goes on. JOE

"rick++" wrote

Could you please clarify? What income tax rate are you anticipating in retirement, when you draw on the VA? What capital gain and dividend tax rate would you have paid in a taxable account during the last four years of bull market?

Columnist Scott Burns, among others, has also pointed out how such income sources can have a devastating effect on the taxation of one's income, due to social security tax laws. Said SS taxation being a very different animal from that to which most of us are accustomed before receiving SS.

No dispute re tax diversification being an option to bear in mind, in view of not being able to know what future tax rates will be. I happen to think income tax rates are headed up, in the long run, to pay for Social Security and Medicare.

Thanks everyone for taking the time to share your expertise and opinions.

Dave

Can you share a bit more about the product you were looking at? Was it an 'indexed' annuity? What were the surrender fees/ mortality fees? Is there a prospectus available on line, for a better analysis? JOE

If someone purchases an annuity with no possibility whatsoever of needing the money within the next six or seven years I don't see why there should be so much focus on surrender charges. Who the heck cares? Why would somebody enter into a contract thinking they might need to withdraw more than what's allowed in the next year or two? Nobody in their right mind would do that. I just don't understand why surrender charges are given so much weight in the annuity discussion as they seem to garner.

And I'm confused as to why annuitizing the contract doesn't come up more in the conversation. This is the fundamental purpose of these transactions, but no one ever talks about annuitizing.

"chris fasano" wrote

Is six or seven years the norm? Seems like an arbitrarily chosen (and low) figure. It seems to me one reason surrender charges are emphasized is because too many investors are sucked in by the other bells and whistles, thinking they can always change their mind, to little detriment. Because of surrender charges, not so.

Because life happens. I don't think there is ever "no possibility whatsoever of needing the money". People get sick, lose their jobs, have parents/children get sick, need money to start businesses, etc. Surrender charges are a risk that do not seem to be balanced with an adequate reward.

-- Doug

Surrender charges are artifact of the times when insurance agents received commissions worth 10-20% of the principle. The insurance company need to lock in money for 5-10 years to turn a profit. The new annuity sellers like Vanguard make money off the internal holdings. So they offer the insurance wrapper at cost, without their penalty, to entice more savings. There are still federal tax penalties for liquidating an insurance product early. Perhaps the Vanguards consider this enough of a disincentive. I agree its not clear the lack of surrender charge gives the customer any more income.

You may be correct, because I havent done this calculation. However, I enjoy not paying taxes YET. I remember the late 1990s when some actively managed mutual funds I had were making double digit distributions. This would raise my tax bracket and require finding or making liquid cash to pay those taxes. Plus computing estimated taxes 5-6 times(*) a year. Not to mention the compounding effects of delaying taxes are more prominant if your investments are deferring double-digit gains. Using deferred instruments like index funds and VAs make taxes more manageable.

(*) The four quarters, the 2nd half of December to look for any useful last minute tax moves, and regular tax time.

Nevertheless, Vanguard (and Fidelity) pose no disincentive against folks rolling their VA to some other VA, which can be done without any tax consequences. They simply don't lock you into their product at all.