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Journal of Financial Planning - November 2006

Variable annuities don't work for investors other than the most aggressive traders. Equity-indexed annuities don't have any advantage over deferred fixed annuities. Immediate fixed annuities usually work well, but not immediate variable annuities.

The Good, Bad, and Ugly of Annuities

by Peter Katt, CFP, LIC

Annuities seem to be more popular than ever—if insurance industry and general financial media focus on them, and the annuity promotion spam I receive, are any indication. Likely this isn't due to individual investors awakening to the advantages of these packaged tax-deferred investment gems. More likely this is driven from the supply side. Let's look at the good, bad, and ugly of annuities, starting with some simple basics.

Types of Annuities

Deferred and immediate annuities. A deferred annuity accumulates value on a tax-deferred basis, whereas an immediate annuity distributes income until the death of the annuitant, with perhaps a guaranteed period for payments that could extend beyond the annuitant's death. Ten years is a typical guaranteed period. A deferred annuity can be exchanged, on a tax-free basis, for an immediate annuity.

Fixed, variable, and equity indexed annuities. Fixed and variable annuities can be either deferred or immediate. Equity index annuities are only the deferred type. Fixed annuities earn value at prevailing interest rates. They cannot suffer losses. Typically, the interest rate will be guaranteed for a period of time, such as five years, after which a new rate will be established for the next guarantee period, generally ranging from one to five years. Variable annuities allow the investor to choose from a family of sub-accounts that include geographic, sector, and broad index stock funds. They also have a fixed account. Some companies offer only variable annuities, with investors wanting only the fixed variety simply using the fixed account. Equity index annuities (EIAs) promise a capped participation in equity returns, with the guarantee no losses will be incurred. As such, although the promotion focuses on the equity participation, EIAs are a hybrid fixed, not variable annuity, and should be compared with fixed annuities.

Annuity Tax Characteristics

All deferred annuities postpone ordinary income taxation on earnings and gains until a future event. Withdrawals from deferred annuities are taxed on an interest-first basis and subject to 10 percent early withdrawal penalty when done before age 59 ½. This makes them quite unsuitable if access to the funds will be needed before retirement. Immediate annuities define a portion of each payment as ordinary income or tax-free return of principal, depending on the cost basis involved.

Upon a deferred annuitant's death, the annuity's gain is subject to income taxes, or often the spouse is the beneficiary with the deferral continuing until the spouse's death, when the gain is subject to income taxes and the entire value is subject to estate taxes depending on the size of the estate.

There are problems with transferring deferred annuities to trusts. Because of this, their value is greatly eroded in estates large enough to be subject to estate taxes. In such circumstances, it is almost always better to exchange the deferred annuity for an immediate annuity and buy life insurance that is owned and payable to an irrevocable trust, using the annuity income to pay the premiums. Depending on annuitants' ages, whether single-life or joint immediate annuity and life insurance are used, and when the second death occurs, the immediate annuity/life insurance combination can double the net value of the deferred annuity, taking all applicable taxes into account.

Variable Annuities

Variable annuities (VAs) are flawed because they convert capital gains into ordinary income and have considerably higher expenses compared with comparable mutual funds. For this reason, they are quite unsuitable for most investors. But for aggressive traders, especially in combination with market timing, the ability to move often among various sub-accounts without any current taxation may make VAs ideal. But this should be tested using various simulations extending over a long period of time before moving ahead with such VA investing.

As lots of positive VA articles attest, VA marketers' use of bells and whistles have successfully created enough of a distraction to avoid dealing with the capital-gain-to-ordinary-income elephant. These creative features include various death benefit riders, certain guaranteed account balance and withdrawal options, and guaranteed annuitization rates. Our examination of each of these features and their costs suggests they don't offset the tax disadvantage.

Bottom line, except for aggressive trading and timing strategies that would substantially benefit from doing so without incurring taxes, VAs are not a worthwhile asset because of their adverse tax characteristics.

The same conversion of capital gains into ordinary income criticism can be noted for qualified pension plans as well. As a macro-investing planning issue it is probably wise to concentrate fixed-income investments in qualified plans and equities outside. Because of tax deductions associated with qualified plans, maximum contributions should be taken. Yet this can cause a large percentage of invested assets to fall inside pension plans. Under such circumstances, an investor's preferred allocation between fixed-income and equity investments should take precedence over this capital-gains-to-ordinary-income issue, making equity investing within a pension plan an appropriate choice.

Equity Indexed Annuities

EIAs offer reduced equity participation but with protection against losses. A typical EIA has a current 6.5 percent cap on equity participation and a 3 percent guarantee, if it is held for a minimum number of years, usually around seven. As noted, EIAs should not be compared with VAs, despite the term "equity" in their title. Instead, they should be compared with fixed annuities. The level of EIA caps will be related to interest rates, not stock prices. Our testing shows EIAs have no investment return advantage compared with a fixed annuity. EIAs tend to have larger commissions associated with them. Larger commissions depress the overall yields; but more important, larger commissions are usually associated with higher surrender charges for longer periods, making them less liquid and flexible. There isn't any outstanding reason to avoid EIAs, but I don't see any advantage over using fixed annuities.

EIA Alternative

In examining the EIA concept, it occurred to me that an interesting alternative is available to investors looking for equity participation but wanting to eliminate losses. Selecting a specific time period, an investor can apportion a percentage of the funds to a fixed-income instrument and the rest to equities such that the earnings on the fixed-income portion will grow during the specified period of time to equal the total investment, making the equity account determine how much gain is achieved. If this is being done via a qualified plan, corporate or government bonds, and perhaps an index mutual fund, can be used. If the investment funds are nonqualified, it might make sense to use a fixed annuity for the fixed-income portion to enhance the deferred yield.

Let's say the total investment is $100,000 and the time period is ten years. Assuming a 5.5 percent fixed-income yield, if $58,540 is invested in the fixed-income component, it will guarantee the original investment of $100,000 in ten years, with the balance of $41,460 invested in equities. Using a Monte Carlo test for the equity portion, assuming a 9 percent arithmetic mean and 20 percent standard deviation, there is a 39 percent probability that the equity portion will generate less than a 5.5 percent actual yield, bringing the overall pre-tax yield below 5.5 percent. This means there is a 61 percent probability it will be greater than 5.5 percent. More precisely, there is a 30 percent probability the overall yield will be 8 percent, 21 percent chance it will be 9 percent, and 13 percent probability of 10 percent.

Annuity Payment Purchases

Certain financial firms have stepped up their marketing efforts to buy immediate annuity payments for lump-sum amounts. Several times during the past few months, national publications have asked me to review and opine on marketing materials and case studies of such transactions. None of the case examples provided a financial advantage to annuitants. Since I would expect the marketing materials to show as much consumer advantage as possible—with actual transactions being of lesser value to consumers—I conclude that these firms are counting on their greater financial math acumen and consumers' relative ignorance to make these deals at considerable profit. Except for investors in desperate need of cash, I doubt the sale of annuity payments is a good idea. For those who do need to raise cash, shop around the sale of annuity payments to enhance the value.

Immediate Annuities

Investors who wish to exchange a lump sum—whether from a deferred annuity or otherwise—for guaranteed lifetime income are immediate-annuity candidates. The obvious disadvantage is giving up the principal, including the ability of leaving it to heirs.

Immediate annuity purchasers in poor health should use companies that are willing to underwrite annuitant applicants. Poor health shortens life expectancy and thus increases immediate annuity income payments. Those in poor health should not buy immediate annuities without this underwriting.

Investors can also buy immediate variable annuities, whose income fluctuates with the performance of the sub-accounts selected. But fluctuating income undercuts the main attraction of immediate fixed annuities. The conundrum is that while immediate variable annuities may be attractive to sophisticated investors, they probably don't want immediate annuities in the first place. The variable approach to immediate annuities may be too clever by half.


An analysis of the deferred annuity scorecard pretty much eliminates all but deferred fixed annuities, which insurance companies aren't really promoting. Except for one type of investor, VAs are not attractive because they convert capital gains into ordinary income. EIAs don't have any particular drawbacks, but are slightly less attractive than fixed annuities. And an investor-built EIA-like combination of fixed income and equity funds should produce a larger upside with the principal guaranteed than the insurance company packaged EIA.

Investors with large estates should probably avoid deferred annuities. If they already exist, they should consider replacing them with a combination of immediate fixed annuities and trust-owned life insurance.

Immediate fixed annuities do the job they are intended for, which is to provide guaranteed lifetime income in exchange for an investor giving up principal. Immediate variable annuities should probably be avoided.

Reprinted with permission by the Financial Planning Association, Journal of Financial Planning, Volume 19, Issue 11, November 2006.

Peter Katt, CFP, LIC, sole proprietor of Katt & Co., is a fee-only life insurance adviser located in Kalamazoo, Michigan (269.372.3497).