Gain Perspective on Variable Annuities

Physician's Money Digest, April30 2003, Volume 10, Issue 8

Although variable annuityinvestments can sometimesseem pretty complicated, thebasic variable annuity is a fairlystraightforward investment vehicle.Essentially, it's an insurance contract"wrapper" around mutualfund investments. These mutualfunds that are offered as investmentalternatives usually span a range of"asset classes," from bonds to variousUS and international stockinvestment categories.

You usually need to pick a varietyof the offered funds to buildyour own asset allocation strategywithin the annuity. Some annuitycontracts, however, offer a "managed"asset allocation strategy (ie,someone else picks the allocation ofyour annuity investments fromamong the various funds). Expectto pay additional charges for thistype of managed annuity fund.

THE BIG ANNUITY PICTURE

Now that you have a betterunderstanding of what a variableannuity is, let's take a look at itsmajor benefit to you as an investor.

The benefit of investing in anannuity is that you receive deferredincome taxation on the gains thatare achieved. But this benefit comeswith some heavy cost detriments.There are some disadvantages whencompared with other investmentalternatives that you should carefullyconsider if you're investing in avariable annuity. The following aresome of these disadvantages:

• High costs. The mutual fundsused as investments within the variableannuity, like all mutual funds,have internal costs involved thatreduce your investment return.However, the funds offered as investmentswithin most variable annuitiesare not among the lowest cost fundsavailable for that investment style.Moreover, in addition to the relativelyhigh cost of the mutual funds,there are additional costs associatedwith the annuity wrapper that furtherreduce your return.

• Gain outcomes. Growth inthe value of your variable annuity istaxed as ordinary income, as opposedto more favorable capitalgain rates, when you withdraw it.When you're young, the long-termbenefit of tax-deferred compoundingmay make up for the differencein tax treatment when you take themoney out. But when you're older,it doesn't make sense to invest instock mutual funds inside an annuity,where the stock gains will ultimatelybe taxed as ordinary income.Instead, you could investdirectly in the stock mutual fund,where your gains will be taxed atcapital gains rates and may actuallyavoid income tax altogetherbecause of stepped-up basis rulesat your death.• Age penalty. If you need towithdraw funds out of your annuitybefore you reach age 59½, you mustwithdraw earnings first. In additionto paying income taxes on the earningswithdrawn (and any early termination penalties payable to the insurancecompany under the terms ofyour contract), you will also paypenalties on the gain amount becauseyou are under age 59½.

• Limited fund investmentoptions. Normally, variable annuitycompanies offer only a fewinvestment alternatives within aparticular class of investments. Thisoften means that you are not gettingthe best funds within a particularcategory. Combined with thehigh costs that are frequently foundwithin the funds and the cost of theinsurance wrapper, a relatively poorinvestment performance meansthat your annuity investment islikely to underperform a directinvestment in a quality fund in thesame market segment.

PRO ANNUITY INVESTORS

Despite these drawbacks, someinvestors still choose to invest invariable annuities. If you are aphysician-investor interested invariable annuities, there are a fewthings you should know before youmake the commitment. The followingis a list of suggestions to keepin mind during the important decision-making process:

• Avoid tax-deferred arrangements.If you invest your 401(k),403(b), or IRA money in a variableannuity, you are needlessly subjectingyourself to higher costs, generallylower returns, and limited fundavailability for no good reason. Theearnings on investments within yourtax-deferred accounts are alreadytax-deferred, and adding the insurancewrapper around them essentiallyaccomplishes nothing.

• Use no-load annuities. Justas there are no-load mutual funds,there are also no-load annuities.These types of annuities usually donot charge a commission or enforcewithdrawal penalties. In addition,they usually have a wider and betterarray of mutual fund investmentoptions. If a variable annuity is trulythe best option for you, the no-loadannuity is likely your best choice.

The good news:

• Consider liquidating yourannuity. If your annuity is substantiallyinvested in the stock market,and its value has declined significantly (ie, the current value is at orbelow what you originally investedin the annuity), consider getting outnow. You will not oweany tax on the gains and you willnot owe any penalty taxes, even ifyou are under age 59½.

In fact, while there might besome limits, you will likely be eligibleto deduct any loss as an ordinaryloss on your tax return. Thisloss can be applied against ordinaryincome, rather than just capital gainincome. The only penalty you willexperience is whatever penalty theinsurance company may charge forliquidating early, which is really asmall price to pay for the tax bene-fits currently available.

In truth, variable annuities aresold as investments more often thanthey should be, in large part becauseof the financial incentivesoffered to sales people for sellingthem. If you are considering investingin an annuity, or already haveone that you are trying to decidehow to handle, talk with an objective,independent advisor to receivethe kind of unbiased help you needto make the best decisions.

Thomas W. Batterman ispresident of the Association ofIndependent Trust Companies,a national organization ofmore than 100 chartered,well-capitalized, and insuredmembers who manage their clients' financialassets during life and after death. Formore information, visit www.aitco.net.