1. What's to Like
As we so often do, let's start with some Foolish conclusions on annuities (so those who absolutely don't want to read all about them have a quick exit strategy) and then explain what they actually are. It's no secret that within the confines of Fooldom, we're not enamored with tax-deferred annuities (TDAs). We do not find ourselves waxing eloquent, sending chocolates, or writing Foolish love poems to annuities, as we sometimes do to individual stocks. The reasons for this are that annuities by and large:
Let's back up for a moment, and, now that we're in the middle of things, restart from the beginning. What, after all, is a tax-deferred annuity? Regardless of who sells it to you (broker, 401(k) plan, Martian), a TDA is a contract between you and an insurance company. In exchange for getting your hard-earned cash today, the insurance company agrees to pay you an income for a specified period or for your life. Those payments may start at some date in the future or they may start on the day you buy the contract. If the payments are delayed until the future, you have what's called a deferred annuity. If the payments start immediately, you have an immediate annuity. You pay for an immediate annuity with a lump sum of cash on the day you buy it. You pay for a deferred annuity either with a single lump-sum payment or with a series of payments made over a number of years. Your investment in the annuity will earn a return, and those earnings will grow untaxed until you receive annuity payments. Be aware, though, that unless you purchase an annuity within an IRA, you will receive no tax deduction for any investment you make in a TDA -- just a tax deferral on your annuity investment earnings. The Types
Tax-deferred annuities come in three flavors: fixed, variable, and equity-index. Fixed Annuities: As the name implies, a fixed annuity provides a locked-in, guaranteed rate of return on the investment and a fixed, stable income in its payout phase. A fixed annuity thus provides a steady retirement income -- but this steady return can and will be eroded by inflation. Options are available (at a price, always at a price) to have your annuity payments increase by 3% to 5% each year should you so desire. When used, the payments under that feature would initially be lower than a fixed payment, but over the years the payments will steadily increase at the specified rate. For those expecting to live many years, the added cost of this feature might be worth the price, but expect to pay dearly for this option. Variable Annuities: Probably the most popular form of annuity these days, a variable annuity allows the purchaser to decide how to invest the money within a range of mutual fund look-alike investment options offered by the insurance company. These investments are called "subaccounts." They often carry the same name and are operated by the same investment managers as publicly offered mutual funds, and they will typically offer a selection of stock, bond, and money market subaccount investments. Nevertheless, they are not the same funds because by law they cannot be. While these subaccounts may invest much like a mutual fund, subaccounts almost certainly will have a different and higher expense structure, and possibly a far different return than that of the public mutual fund. Thus, like a mutual fund and unlike the fixed annuity, the returns of the variable annuity are not stable, and will vary along with the markets. While this variability does carry downside risk, it nevertheless affords the annuity buyer the ability to participate in the potentially greater returns of the stock market. As the stock market rises, so does income derived from an investment in a stock subaccount. Conversely, as the market declines, so will income. Still, over the long-term, a variable annuity invested in a stock subaccount should provide a much better opportunity for inflation-protected income than a fixed annuity. Equity-index Annuity: A recent innovation in the insurance industry, an equity-index annuity is a form of a fixed annuity contract tied to a stock index that provides the opportunity to earn returns better than those in a traditional fixed annuity, but less than those of a direct investment in the market itself. In this contract, the insurance company invests in a mix of bonds and stock options designed to give a targeted participation rate (explained below) on the return of a particular index (e.g., the S&P 500 Index). While the purchaser has no choice in the investment itself, he or she is able to participate to a degree in stock market gains during a rising market. If stocks fall, then the contract guarantees a minimum return, typically 3%. Because of that guarantee, the equity-index annuity has less downward volatility than the variable annuity. There's no such thing as a free lunch however, so the equity-index annuity will also limit the maximum returns of a rising market as compensation for that guarantee. Most equity-index annuities use something called a "participation rate" to limit returns. For instance, the insurance company may declare a participation rate of 90% (some companies are as low as 50%), which means the annuity would be credited with only 90% of the gain experienced by the equity index for that year. If the index gained 10%, then the gain in the annuity would be 9% for the year. And that's not the only way these annuities limit the return. Most will also tie equity-index returns to those deriving from market price changes only, and exclude any return due to the payment of dividends. As an example, in 1998 the total return (i.e., capital gains and dividends) for the S&P 500 Index as reported by Ibbotson Associates was 28.6%, while that for just capital gains (i.e., market price) was 26.7%. An equity-indexed annuity tied to the S&P 500 Index would typically use the smaller 26.7% return. Couple that with a participation rate of 90%, and the return in the index annuity becomes just 24%, some 4.6% below the total return of the market. How's that for a double-whammy? It's Your Choice
For retirees, an annuity offers the assurance of a stream of income for life or for a specific period of time. For those who fear the potential loss of all their money because of poor investment choices, that "guarantee" is important. As Fools, we recognize that this "fear factor" is real and does enter into many people's investment decisions. Accordingly, we fault no one who chooses lower risk approaches, and that's especially true of those who are retired. But as Fools, we do urge those interested in annuities to recognize their costs, their investment limitations, and their limited potential for passing on wealth to heirs. If, after evaluating all those factors, an annuity still appears appropriate, then as Fools we also urge the purchase of a low-cost annuity such as one offered by Vanguard, T. Rowe Price, Fidelity, AnnuityNet.com, or (in some states) TIAA-CREF. Why pay commissions and high expenses when you don't have to? That enriches the fat cats at your expense, and no Fool wants to do that. Keep the money in your pocket instead. Annuities market themselves on the basis of their ability to avoid taxation on investment growth through tax-deferral. While it is true that taxes on earnings are deferred within an annuity, this may not be achieved in a way that is quite as useful as it sounds. Read about the real pros and cons of annuity tax-deferral next. 2. Taxation Avoiding taxes is, when done legally, one of those things that almost everyone truly enjoys. There are very, very few people who will wax eloquent about the pleasure of paying taxes, and of those that do, not many get elected, and they are generally avoided at cocktail parties as well. Seizing upon this long history of the American populace voting with their pocketbooks when taxes are concerned, brokers and insurance agents have discovered that they can sell some pretty expensive products that come shrink-wrapped in the "Tax-Deferred Growth!" packaging. But, like any product that has an attractive label on the front, looking carefully at the small-print list of ingredients is recommended. The most attractive feature to most folks about an annuity is precisely that tax-deferred growth. And, indeed, as long as the money remains inside the annuity, the government won't tax any of the earnings. But all good things must come to an end, and sooner or later a tax-deferred annuity is going to get taxed. Let's take a look, then, at how and when that happens. A deferred annuity has two phases, the accumulation phase and the distribution phase. During the accumulation phase, the annuity grows untaxed through the years as the investment compounds. In the distribution phase, the annuity is paid out. The payment may be made as one lump sum or as a series of scheduled payouts over a specific period or a lifetime. In insurance-speak, a series of scheduled payments is called "annuitization," and the recipient is called the "annuitant." Regardless of the payment method, some income taxes will by due on every annuity payment the annuitant receives. If the payment is made as a lump sum, then income taxes will be due on the difference between the amount paid into that annuity and its value when it is paid back. Taxes on a Lump-sum Distribution As an example, let's say you invested $100,000 over the years into a TransFirstLife annuity that's worth $250,000 when you retire at age 62. If you take that amount in a lump sum, you will owe taxes on your gain of $150,000. Fair enough -- the $150,000 is an investment gain, and just about all successful investments require that taxes be paid someday. But, Uncle Sammy says that an annuity gain is ordinary income, so the taxes you will pay on that amount will be computed based on the ordinary income tax rates in effect in the year of distribution. You get no capital gains tax break on your earnings. Yikes! Taxes on Annuitizing If you annuitize, part of each payment is considered as a return of previously taxed principal (i.e., your investment) and part as earnings. (Think of it as the reverse of paying a mortgage, where part is principal and part is an interest payment.) You will owe income taxes on the part of the payment that's considered earnings. The amount of each payment that won't be taxed is computed by establishing an "exclusion ratio" that's determined by dividing your investment in the contract by the total amount you expect to a receive during the payout period. The interested reader should see IRS Publication 939, General Rule for Pensions and Annuities, for the details on how to calculate taxes due on annuity payments. As an illustration, assume you have a fixed annuity in which you've invested $100,000 that will pay you a sum of $750 per month for life starting at age 62. According to IRS life expectancy tables, you will receive those payments for 22.5 years, so your contract's value is $202,500 (12 X $750 X 22.5). Your exclusion ratio is 49.4% ($100,000/$202,500). Therefore, out of the $9,000 the annuity pays each year, you may exclude $4,446 from income. The remaining $4,554 of that payment will be subject to ordinary income taxes. Taxes on Variable Annuities Taxes on a variable annuity work a little differently. In a variable annuity, you don't actually know how much the annuity payment will be each month because the market value of your investment will change based upon what stage of its manic depression the market is in. Accordingly, the excludable amount of each annuity payment is determined by dividing your investment by the period over which you expect to receive the annuity. In the preceding example, the annuity would make a payment for 270 months (12 X 22.5). Therefore, if the investment was in a variable annuity, the amount to be excluded from every monthly payment would be $370 ($100,000/270). The remainder of each payment would be declared and taxed as income for that year. The Confusing Case of Withdrawals A withdrawal is any amount distributed from the annuity that is not part of the annuitization process. Those payments are taxed based on when the annuity was purchased. Investments made after August 13, 1982, are taxed on a last-in, first-out basis. That means for income tax purposes the first money out of the annuity will be considered as earnings, not principal, and will be taxed as ordinary income when withdrawn from the contract. Additionally, just like a traditional IRA, withdrawals made prior to the annuitant's age 59 1/2 are subject to a 10% early withdrawal penalty. If the annuitant dies prior to receiving any payments, then the money will go to the contract's beneficiaries. On receipt, the beneficiaries will be taxed on the earnings in the annuity at ordinary income tax rates. If the contract had been annuitized prior to the annuitant's death, then there may or may not be an income tax impact. If the annuitant opted for a life only annuity, then at death nothing passes to heirs and no income taxes are due. If the annuitant selected a term-certain option and died before that period elapsed, then remaining payments will be paid to someone, and the recipient will pay ordinary income tax on all earnings previously unpaid to the deceased. A joint-life annuitant (e.g., a surviving spouse) will continue to receive an income tax exclusion on part of the annuity payments until the entire investment in the contract is recovered. We did mention that the tax-deferred advantage was part of selling an expensive product, right? Read Fees and Expenses to see what we mean by that. 3. Fees and Expenses Just like other investments -- good and bad -- annuities have fees and expenses. What distinguishes them from most good investments, however, is that annuity fees are quite high. For this reason alone, annuities generally receive heaps of bad press -- and at least in this limited regard, we're siding with the mainstream conventional press. To be fair, we'll mention that costs do vary from product line to product line and company to company, and that variable annuities have more features than fixed annuities, so fees and expenses within a variable annuity are generally higher than those found in fixed annuities. A shopping list of the types of fees that go into annuities is as follows: Mortality and Expense Charges The first fee typically imposed by an annuity will be what's known in the industry as a "mortality and expense" (M&E) charge. This fee pays for the insurance guarantee, commissions, selling, and administrative expenses of the contract. In general, these fees in a variable annuity will be charged as a percentage of the average value of the investment and will probably be quoted in terms of "basis points." A basis point is 1/100th of 1%. Thus, an M&E charge of 115 basis points means a fee of 1.15% will be assessed against the value of the investment. According to the National Association of Variable Annuities (NAVA), the industry average M&E in 1997 was 1.15%. In a fixed annuity, these charges are usually incorporated in the insurance company's determination of the periodic interest rate or the annuity payment amount during the distribution phase. Surrender Charges The existence of surrender charges should alert many a Fool that annuities are something to be treated with skepticism. Many annuities will impose a surrender charge if the annuity is cashed in before a specific period of time. That period may run anywhere from 1 to 12 years. A typical surrender charge is one that starts at 7% in the first year of the contract, and declines by 1% per year thereafter until it reaches zero. The charge is made against the value of the investment when the annuity is surrendered, and its purpose (other than simply to make money for the insurance company) is to discourage a short-term investment by the purchaser. For that reason, an annuity should always be considered a long-term investment. In the typical fixed annuity, though, this charge will not apply provided no more than 10% of the investment is withdrawn per year. Management Fees Management fees on subaccounts are assessed by variable annuities, and they are the same as an investment manager's fees in a mutual fund. These fees will vary depending on the various subaccount options within the annuity. In general, they will be somewhat less than those charged by a managed mutual fund within the same investment category -- though not necessarily. According to NAVA, the 1997 industry average for subaccount management fees was 82 basis points, or 0.82%. That's somewhat lower than many managed stock mutual funds, but it's over four times that of an unmanaged stock index fund like the Vanguard Index 500, which only charges 18 basis points. Also, just as an aside, the returns published by an insurance company for its annuity subaccounts will be the net returns after all management fees have been deducted. So, just as a mutual fund's stated return does not reflect the impact of any sales commissions, the subaccount return does not reflect the impact of M&E charges that have been assessed against the investment. Conclusion The fees and expenses imposed by annuities indicate they are undoubtedly costly to own, and they absolutely are not meant for the short-term investor. Get out early, and the surrender fees could swallow a large hunk of cash that would take years to recover in a taxable alternative. Additionally, of the over 11,000 mutual funds in existence in 1999, expenses exclusive of loads average between 1.2% and 1.5% (depending on which study you use) compared to the nearly 2% in management and M&E fees charged by the typical variable annuity. For no-load funds, expenses average only 90 basis points, less than half that of the average variable annuity. Assume you are a long-term, buy-and-hold investor who wishes to invest $20,000 in either a taxable S&P 500 index fund or a similar S&P 500 index subaccount with identical expenses within a tax-deferred variable annuity. Assume the investment in either option will earn an average annual return of 11.2%, of which 4.5% comes from dividends. In the taxable account, you will pay income taxes on dividends as received. The annuity will impose an M&E charge of 1.15% each year. Which investment will give you the most money after taxes at the end of 20 years? After paying income taxes at a marginal rate of 28% on your annual dividends, the taxable account would have a net annual return of about 9.9%. At the end of 20 years, the investment would have grown to $132,125. Your long-term capital gain would be $112,125 taxable at 20%. After paying your tax of $26,425, you would be left with a total of $105,700. The annuity would have a net annual return of 10.05% after the M&E charge (11.2% -- 1.15%). At the end of 20 years the investment would grow to $135,778, or some $3,600 more than the taxable account. Your gain would be $115,778. All of that gain, though, is taxable at ordinary rates. If taxed at a marginal rate of 28%, your tax bill would be $32,418. That means you would net $103,360, or about $2,300 less than that of the taxable account. Hmmm... Maybe the tax deferral in the annuity wasn't everything that it was hyped to be. It seems as though those M&E charges coupled with ordinary income taxation on annuity gains offset the tax advantage during the annuity's accumulation phase. Indeed, your income tax rate would have to drop in 20 years for the annuity to come out on top in this case. Will it? Only you can answer that.
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