Are You Buying Annuities Or Mutual Funds?

Gerald and Ashley were knee-deep in their annual discussion of their finances. Gerald looked at his retirement plan statement again. "Well, it says here that my portfolio is allocated between two Oppenheimer funds, one Franklin fund, one Eaton Vance fund and a Davis fund."

Ashley was unimpressed. "Gerald, if we're invested in all of these different companies, then why is there only one telephone number given to call if we have questions? And why is the number given the number to an insurance company? I thought you said that we were invested in mutual funds!"

"Well, we are invested in mutual funds. That's what our broker told us, anyway!"

Gerald and Ashley's hypothetical conversation exemplifies the confusion that many investors experience when they examine their Individual Retirement Accounts (IRAs), or other retirement plans, that are largely in variable annuities. Financial planners, insurance agents and stockbrokers have been investing their clients' retirement money into these insurance products for decades. (An Overview Of Annuities provides a quick primer on the products.) But increasingly, this practice has been getting them a lot of flak from the financial media and other financial advisors. The criticism centers around two main subjects: commissions and taxes.

Disparity in Commissions
Critics claim that those who utilize annuities are motivated primarily by commissions. Straight mutual fund investments almost always pay smaller commissions than annuities of any kind.

Breakpoint reductions in mutual fund commissions only serve to widen this gap. For example, a client that rolls a $500,000 401(k) into an IRA and invests the entire balance in, say, Franklin funds will only pay a collective sales charge of 2%. Most fixed annuities or variable annuities, however, pay commissions ranging anywhere from 5-7%, or even higher in some cases. Therefore, a $500,000 IRA rollover into Franklin funds would pay the planner a $10,000 commission at most, while the same rollover into a variable annuity offering Franklin funds could easily pay the planner anywhere from $25,000 to $35,000 in gross commission. Consequently, many planners will simply direct their clients into an annuity with little or no discussion about the differences in fees or sales-charge structure.

Because most variable annuities do not assess front-end sales charges, they may appear to be no-load investments to uneducated clients. But they do have fees and expenses that must be considered. Most variable contracts have five- to seven-year back-end surrender charge schedules similar to B-shares in mutual funds. As for the lack of front-end fees: The majority of these contracts make up for this by assessing annual maintenance and operational charges that often end up being more expensive in the long run than A-share mutual funds. But planners who work with long-term investors can easily gloss over this issue during the sales presentation. (For more insight, read Variable Annuity Benefits: What The Fine Print Won't Tell You and Getting The Whole Story On Variable Annuities.)

No Added Tax Deferred Benefit
Another more pressing and straightforward issue is that of tax deferral. Annuities are tax sheltered vehicles, meaning your contributions reduce your taxable earnings for the current year, and your investment earnings in them grow tax-free until you begin to draw an income from them. But  because IRAs and other retirement accounts already grow tax-deferred, no further tax advantage of any kind can be achieved by investing the money inside them into variable annuities. It's like wearing a belt and suspenders. This is why so many advisors suggest maxing out IRA and 401(k) plan  contributions first, then funding annuities and keeping them in a regular account – the type that normally is subject to taxation – where their tax-advantaged feature won't be redundant.

Insurance Feature
Despite the criticisms listed above, variable annuities do have their advantages. One of them is that annuities can provide is a measure of insurance protection for the contract value. Variable annuity proponents argue that clients should insure their retirement plans the same way that they insure all of their other major assets. Because they would never think of owning a house or car without insurance, why risk a retirement plan?

Riders Can Provide Guarantees
The living and death benefit riders offered within most variable contracts today can provide critical principal protection for investors who may still need equity exposure in their retirement portfolios.

For example, the guaranteed minimum income benefit rider that many variable annuities offer provides a guaranteed payout at a specified rate of growth, regardless of the actual performance of the underlying mutual fund sub-accounts. Therefore, a client who invests $500,000 in a variable annuity and opts for this rider can enjoy a guaranteed growth rate (say, 7%), and then a guaranteed stream of income. Furthermore, the income streams received by contract holders will usually also satisfy their required minimum distributions (RMDs). Other riders can periodically lock in the contract value and guarantee that the client will never receive less than that value out of the contract, even if the actual market value of the underlying funds were to decline substantially. Of course, these riders come at a price, but many planners feel that the cost is justified, particularly with older clients who won't have time to recoup market losses.

Auto-Pilot Management

Variable annuities contain a number of professional money management features, such as dollar-cost averaging, value averaging, periodic portfolio rebalancing and a wide selection of funds and fund families to choose from. (To read more about insurance riders, see Let Life Insurance Riders Drive Your Coverage.)

While there is a fair amount of gray area in this matter, one alternative for a planner is to allocate clients' retirement portfolios in straight mutual funds before retirement, and then move their accounts into variable contracts once they stop working. This approach could allow for more streamlined growth before retirement, and then provide continued growth with downside protection during the client's later years. Once the main income earner has stopped working, capital preservation becomes a primary goal because there will be nothing else to replace primary cash flows. If you're concerned about the drawbacks of investing in variable annuities, you could broach this strategy with your advisor.

In the final analysis, there may be no real right or wrong in this issue. The only real requirement that planners must satisfy is ensuring that their clients understand the costs (both real and opportunity costs), fees and risks involved in their investments, whether they are annuities, mutual funds or any other vehicle. Annuities from traditional low-cost providers are increasingly offering very low annual expense ratios for key rates like the mortality expense and management fees.

At the end of the day, financial planners will likely have to examine this issue on a case-by-case basis to determine whether variable annuities are appropriate for their clients. people often get misguided into buying these annuities.