2003 Lane Reports

Annuities...Are Their Benefits Worth Their Costs?

Thursday, May 1, 2003

Since the Roman Empire, annuities - - or "annua," as they were originally called in Latin - - have attracted many investors to the benefits of earning a lifetime income stream in exchange for a one-time investment. Annuities were created to generate revenue for governments, while also offering financial security for the average person. Initially, it was a "win-win" situation, and annuities were quite simple. Modern-day annuities are much more complex, offering bells and whistles, but at a substantial cost that could erode their long-term potential.

Today's annuities stand out from other investment products because they offer tax-deferred savings, all kinds of guarantees, and lifetime income. Unfortunately, the costs and consequences associated with these perks - - including exorbitant annual expenses, loss of liquidity, and profits which are converted from tax-favored capital gains to possibly highly-taxed ordinary income - - have clearly dulled some of the annuity's luster.

The annuity business is a multi-million dollar industry, and investors continue to flock to annuities. But what is the truth behind the bells and whistles? Here is a rundown of what you are getting for your money:

Expenses and Fees…Be prepared to pay.

Aside from taxes, fees will eat away at any earnings you stand to gain from owning an annuity. All annuities assess some, if not all, of the following fees:

Mortality and risk fees-When you buy an annuity, you are purchasing an insurance product. Insurance products assess annual mortality and risk fees to compensate for the insurance risk the annuity provider assumes under the annuity contract. The annual fee ranges from 1.25% to 2% of the annuity value. A portion of this fee is typically used to cover costs associated with selling the annuity, such as marketing expenses and commissions.

Example: Your annuity charges an annual mortality and risk expense of 1.25% of your account value. If your average account value is $100,000, you will pay an annual mortality and risk expense of $1,250 that year. Keep in mind, as your average account balance increases, so will the fee you pay.

Administrative fees-
The insurer customarily charges an annual administrative fee for recordkeeping services. This fee is likely to be $25 to $50 each year.

Underlying investment expenses-
For variable annuity contracts, you'll be required to pay an annual fee imposed on the underlying mutual fund "sub-accounts" you choose. This fee is determined by the mutual fund companies which manage the sub-accounts, and cost on average from 0.5% to 1.50% for each mutual fund sub-account held in the annuity.

Fees and charges for additional features-Guaranteed death benefits, long-term care riders, living income benefits, and extra credit sign-up bonuses all add extra fees and extended surrender periods to your annuity contract.

Lack of Liquidity…Lock it up and throw away the key.

When you sign up for an annuity, you are also agreeing to tie up your money for approximately 6 to 8 years, sometimes as long as 10 years. If you withdraw money from your annuity earlier, the insurance company will assess a "surrender" charge, which is a type of sales charge that is typically used to pay commissions. Generally, the surrender charge is a percentage of the amount withdrawn, and declines gradually over a period of several years. It is customary for the annuity contract to allow up to 10% of the contract value to be withdrawn each year without a surrender charge. Some companies offer annuity contracts without a surrender period, but the initial investment requirement and the mortality and risk expense tend to be higher.

Example: After purchasing a $100,000 annuity contract that has a schedule of surrender charges, beginning with an 8% charge in the first year and declining 1% each year, you realize in year 3 that you have no other choice but to withdraw $20,000 for an emergency. If the contract value in year 3 is $105,000, the first $10,500, or 10%, can be withdrawn without a surrender charge. The remaining $9,500 will be assessed a surrender charge of 5%, or $475.

An annuity should never be thought of as an emergency resource, due to the surrender charges in the early years and the tax implication in future years.

Annuities and Taxes…Good news/bad news.

The most appealing feature of annuities is the tax deferral on earnings. Tax-deferral is a powerful tool, especially over the long haul. Since the actual returns of your annuity's funds are not eroded by taxes year after year, they'll compound faster. Over time, you may be able to accumulate substantially more in a tax-deferred variable annuity than in a taxable investment earning the same rate of return - - which means more income for you at retirement. Now, for the bad news…earnings withdrawn from annuities are taxed at ordinary income tax rates, which are as high as 38.6%, compared to the maximum capital gains rates for mutual funds, only 20%. Although investors in high tax brackets benefit from tax deferral, they also assume a higher tax burden when they withdraw money from an annuity.

Assets held in IRAs and qualified plans, such as 401(k)'s, should never be invested in an annuity. Since they are already tax-deferred, it is redundant to invest them in an annuity, and the fees you'll pay for the annuity are significantly higher than with other investment options. Also, taxable investments will be taxed at possibly higher ordinary income tax rates, and not at lower capital gains rates.

Owning annuities can also present problems for heirs. There is no "step-up" in the cost basis upon death of the annuitant, so heirs are responsible for paying taxes on earnings in the annuity. For that reason, annuities are not the best investment vehicle for building wealth to pass to your heirs.

I would not recommend that most people invest in annuities, but they can be suitable investments for some:

For older individuals who began contributing toward retirement late in life, annuities are a way of catching up.

If your employer does not offer a retirement plan, contributions are not as limited as they are with IRAs.

If you have contributed the maximum amount to your employer's plan and would like another tax-deferred vehicle to invest in besides IRAs, annuities might fit the bill.

High expenses, lack of liquidity, and avoidable tax costs should all be seriously considered before deciding on an annuity. The benefits of tax-deferred growth will only outweigh the costs and consequences of annuities if the contract is held for the long-term as a means to meet your retirement needs and other long-range goals.

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The Lane Report is a publication of The Law Offices of Marc J. Lane, a Professional Corporation. We attempt to highlight and discuss areas of general interest that may result in planning opportunities. Nothing contained in The Lane Report should be construed as legal advice or a legal opinion. Consultation with a professional is recommended before implementing any of the ideas discussed herein. Copyright, 2003 by The Law Offices of Marc J. Lane, A Professional Corporation. Reproduction, in whole or in part, is forbidden without prior written permission.

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