The Economy

Beware the Fine Print

Despite some welcome improvements, variable annuities still scream ''caveat emptor.''
Marie LeoneMarch 1, 2007

The web version of this article has been expanded to include the sidebar “Second Time Around,” which did not appear in the March print edition of CFO magazine.

At a family gathering this past Thanksgiving, the head of the household suddenly announced that he was planning to invest in a variable annuity as part of his retirement portfolio. The patriarch started to explain why, but before he could get in another word his son-in-law, a university tax professor, gasped: “Are you crazy?”

Annuities have garnered a bad rap in some circles, and not without reason: from unscrupulous sales tactics to inflexible and potentially costly contracts, annuities have caused some investors a lot of grief.

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But that hasn’t dimmed enthusiasm. Over the past 10 years, annual sales of annuities have increased every year, jumping from $74 billion in 1996 to $133 billion in 2005, says trade group NAVA. That’s an 8 percent annual growth rate.

What’s fueling the interest? For starters, most retirement-planning models end at age 85; many people do not. (The U.S. Census Bureau estimates there are currently 5.2 million citizens aged 85 and over.) The promise of a guaranteed lifetime benefit, plus certain tax advantages and potential protection from downside risk, has made believers out of many. Annuities also provide diversification. In fact, Bruce Schmidt, an estate attorney with Howd, Lavieri & Finch LLP, in Winstead, Connecticut, contends that investors should view annuities as a substitute for bonds — assuming they can live with a conservative investment with limited liquidity.

Twists, Turns, Fees

Essentially, an annuity is a reverse life-insurance policy. While a typical insurance policy protects the buyer who might die too young, an annuity protects the buyer who lives too long.

It works like this: A customer pays an insurer a lump sum up front. In exchange, the seller guarantees that customer an income stream over a set period of time — often a lifetime. The insurer is betting that the buyer will die early enough to be financially advantageous to the carrier; if the policy does not contain a death benefit, the insurer keeps what’s left of the principal.

Annuity contracts come in two varieties, immediate and deferred. Immediate annuities begin paying out with the purchase of the policy; deferred contracts pay out some time in the future. The payouts themselves can be fixed or variable. Fixed annuities offer prescribed payments, similar to a traditional defined-benefit pension plan. The payment stream from a variable annuity is based on the performance of an underlying subaccount investment, similar to a mutual fund. Therefore, the payout can end up being greater than first estimated.

One major knock against annuities has been their relative lack of liquidity. An insurer assesses “surrender charges” (typically beginning at 8 or 9 percent and declining each year, but sometimes as high as 25 percent of the contract value) when an investor withdraws some or all of the value before the holding period expires.

Most variable annuities sold today have some sort of enhanced liquidity provision, says Marc Del Gaudio, managing partner at Langdon Ford Financial, a financial-services firm that sells annuities and mutual funds. Typically, the provision allows a buyer to withdraw between 10 and 15 percent of the contract value annually without incurring a surrender charge. Be forewarned, though: in most cases, the Internal Revenue Service charges a penalty if an annuity holder makes a withdrawal before the age of 591/2. There is a secondary market in which customers can sell their annuities for 75 to 95 percent of the value, but many restrictions apply.

If that sounds confusing, it gets worse. Experts say the biggest drawback to annuities is the complexity of the contracts. The policies are often full of unexpected twists, turns, trapdoors, and fees.

Management fees and other charges for the subaccounts often top 2 percent, much higher than the 1.4 percent average charge for mutual funds. Annuity holders are also charged an annual account fee. On top of that, a slew of riders designed to add flexibility to a policy can add to the cost.

Tax consequences are mixed. Deferred annuities do offer some advantages: since payment to the IRS for asset appreciation is deferred, the money in the account can compound tax-free for years. Nevertheless, it takes at least 12 years for an annuity’s tax deferral to catch up with profits generated by low-fee mutual funds. And unlike mutual funds, which are subject to the 15 percent capital-gains rate, annuity payments are classified as ordinary income — and taxed accordingly.

Attorney Schmidt also warns that an annuity cannot be transferred to a trust without a change of title. That shift in ownership requires the recognition of income in the annuity — and exposes the funds to Uncle Sam. What’s more, annuities are not eligible to take advantage of the capital-gains step-up provision for trusts. Thus, if an initial investment of $1 million is made in an annuity and it grows to $1.5 million over time, the heirs will have to pay a tax on ordinary income of $500,000 for the annuity. A similar transfer of a stock portfolio would trigger no tax event. Says Schmidt: “It all comes back to, why do you want to buy an annuity?”

Lifetime Guarantee

For many, the answer can be found in the promise of income for life, and, more recently, in improved control over the annuity. In 2005, the insurance industry introduced a variable annuity that features guaranteed lifetime withdrawal benefits (GLWB). The rider locks in a percentage payout based on the initial deposit that may increase if the value of the underlying accounts goes north, but can’t decrease if it goes south.

If, for instance, the initial deposit is $500,000 and the contract pays 5 percent annually, the owner is guaranteed $25,000 a year for life. If the annuities’ underlying subaccounts perform well and the value of the assets rises to $600,000, the owner receives $30,000 that year. If the account value drops to $400,000, the owner still receives the guaranteed $25,000. These GLWB annuities also provide more flexibility over the principal because withdrawal penalties are waived after seven years (or less, depending on the contract terms).

Like other riders to annuities, however, this feature comes at a cost. The price of the GLWB option usually runs about 50 to 75 basis points of the total contract value. Currently, a $500,000 annuity with a GLWB rider costs an additional $2,500 to $3,750 per year, estimates Del Gaudio.

Still, for high-income earners in their prime work years, GLWBs may make sense. Certainly, the thought of getting some market upside potential, with a guaranteed base, is appealing. Says Del Gaudio: “GLWBs are the best thing to come along in terms of retirement-planning flexibility in the past several years.”

Marie Leone is senior editor of

Annuity Checklist

A sheet to stop cheats

  • Do a credit check on the insurance company selling the annuity.
  • Make sure you understand the annuity contract, which may require making the salesperson explain the contract in plain English and in writing.
  • Have a lawyer review the contract. Make sure the lawyer has no connection to the broker pitching the annuity.
  • Ask the salesperson to provide a written list of all fees and charges associated with the contract. The most common fees to check include:

    Mortality and expense. The basic annuity fee that the insurance company charges to develop the product.

    Mutual-fund fee. The underlying expense ratio for the mutual-fund company, covering such costs as research, and buying/selling stocks.

    Contingent deferred-sales charge. A back-end sales surrender charge that often decreases as the annuity ages, and is usually eliminated after 8 to 10 years.

Source: Bruce Schmidt, Marc Del Gaudio

Second Time Around

“Annuities are not bought, they are sold.” So goes the old industry adage about the investment vehicle with the bad reputation. One of the more potent problems investors have with annuities is that they are not very liquid. While insurance companies that back annuity contracts provide a guaranteed long-term payout, the contract owner usually has to give up access to the principle—usually for five to seven years—or pay big surrender charges to withdraw any remaining principle. Those charges can run anywhere from 6 percent of the assets up to 25 percent, depending on the contract.

Some insurance companies are willing to work with owners to strike a deal the investor can live with. But when that fails, the secondary market may be a worthwhile alternative. Finance companies that deal with short-term credit have been trading in the secondary annuity market for about 15 years, mostly focusing on swapping long-term lawsuit settlement payments for a lump sum payout. Over the past three years, however, the same finance companies have been increasingly buying annuities from owners who purchased the product from insurance companies or inherited the asset.

Policy holders look to cash out their annuities early for any number of reasons, says Michael Vaughan, managing director at J.G. Wentworth, one of the companies that trades in the secondary market. Their motivation can range from spotting a better investment opportunity, to funding college or medical expenses, to buying a second home. Wentworth, and other companies, such as Novation Capital and Federal Settlement Group, buy annuities from owners, securitize the assets, and bundle the contracts for sale to institutional investors. The lump-sum payment is based on the contract terms and interest rates, and typically ranges between 75 percent and 94 percent of the asset value of the annuity, estimates Vaughan.

But the devil is in the details. Both guaranteed and life-contingent annuity payments can now be sold in the secondary market. However, annuities that are part of a qualified-retirement account as defined by the IRS, such as 401(k) plan, cannot be sold.—M.L.