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 everif 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.
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
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.
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.
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.
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 possiblewith actual transactions being of lesser value to consumersI 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.
Investors who wish to exchange a lump sumwhether
from a deferred annuity or otherwisefor guaranteed lifetime income
are immediate-annuity candidates. The obvious disadvantage is giving up
the principal, including the ability of leaving it to heirs.
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.
Reprinted with permission by the Financial Planning Association, Journal of Financial Planning, Volume 19, Issue 11, November 2006.