Variable annuities are among the mostpopular investment products becausethey supposedly offer great tax and otheradvantages. In reality, they are not suitable formost investors. They have too many embeddedcosts; they're inflexible with the high expensesinvolved in taking money from them inthe early years; and while they offer taxdeferral, they also convert what could below-tax, long-term capital gains intohigher taxed ordinary income.
SMOKE AND MIRRORS ACT
They're popular primarily becausethey're sold with great enthusiasm by anarmy of agents, who receive large profitsfrom selling them. But in the recentmarket debacle, variable annuities raninto the same problems as most mutualfunds. Since investors in variable annuitieshad a lot of their money in equitysubaccountsâ€”often highly risky andpoorly managed onesâ€”they lost tons ofmoney. That, of course, dampened thepublic's interest in them.
So the insurance companies havecome up with a new generation of variable annuitiesthat seems to offer the best of all worlds. If themarket goes up, the investor will make money; ifthe market goes down, the investor will still makemoney. How can you beat that?
YOUR STANDARD PROPOSAL
I call these Santa Claus variable annuitiesbecause these claims are about as believable asSanta Claus. Since they may be coming to your livingroom soon, be sure you know what they looklike and why you should avoid them.
Typical pitch for a Santa Claus annuity
: Whenyou invest $100,000, the insurancecompany will immediately kick in a5% bonus, letting you invest$105,000 in the subaccounts. Thismoney will grow at least at a 7%rate per year so that at the end of10 years you will have aminimum of $210,000.In the meantime, you can invest themoney in any of 50 or 100 availablesubaccounts. Since you have the downsideprotection, you can afford to investall of your money in the highly riskyfunds that you wouldn't dream ofinvesting in otherwise.
At the end of 10 years, if your funddoes spectacularly well, you will getto keep your windfall. But if yourfund collapses to $15, you will stillget your $210,000. How can youresist such a deal?
But wait, there's more if you makeup your mind within 15 minutes.Every quarter, your account value willbe ratcheted up to the new high valuethat your account may attain. That'scalled the high-water mark.
DEAL'S LITTLE HITCHES
So at the end of the 10 years, you will get$210,000, the final account value, or the highestquarterly value your account attained over theyears, whichever is greater. You not only benefit ifthe market goes up a lot, but you even benefit if themarket goes up significantly and then goes down towherever it goes down to. Just think, you can be theworld's greatest market timer without even trying.
You know enough by now to ask, "What's thehitch?"To figure it out, you'll only need a PhD infinance, 10 years of training ininterrogation, some very brightlights, and an infinite amount oftime to keep interrogating youragent until you get the whole truth.At least that's what it felt like to mewhen I gave it a try.
: First, the policy Ilooked at had a built-in cost of about 4.6%, someof which you can find with some diligence, andthe others will take that PhD in finance. So if theminimum guaranteed return is 7% per year, yourfund will have to return more than 11.5% per yearto do better. The chance of that happening overthe next 10 years is very low. Similarly, the chanceof any of those quarterly high-water marks turningout to be higher than the $210,000 is also verylow. So these options are lottery ticketsâ€”they maypay off big, but they're most likely useless.
WHAT TO REALLY EXPECT
You'll at least have that guaranteed $210,000,right? That's not too shabby. It wouldn't be sobad if you actually got that. When you read thefine print or interrogate long enough under abright enough light, you'll find out that you can'treally take out that $210,000 at the end of 10years. You will have to annuitize it for the rest ofyour lifeâ€”at a 2.5% interest rate.
So, in one of these policies, you will effectivelytie up your money for the rest of your life,earning somewhere around 4% to 5% interest,which will get taxed at the ordinary income taxrate when you receive the annuity payments. Youwill have the privilege of all the risk of inflationkicking up and eating away much of that return.You also get the privilege of buying some veryexpensive lottery tickets. No one needs a variableannuity with a lot of bells and whistles.
Chandan Sengupta,author of The OnlyProven Road to InvestmentSuccess (JohnWiley; 2001), currentlyteaches finance at theFordham UniversityGraduate School ofBusiness and consultswith individuals onfinancial planning andinvestment management.He welcomesquestions or commentsat email@example.com.