Ask an investment advisor aboutvariable annuities and they'relikely to flash a disapprovingscowl. That's because variable annuitiesare generally considered to be horribleinvestment products. However, columnist JonathanClements points out that there are circumstanceswhen purchasing a variableannuity can make sense.
Understand the Product
Variable annuities allow individualsto purchase mutual funds within atax-deferred jacket. The knock onthese investments is their exorbitantfee schedule, due in part to their insurancefeature that guarantees a particularsum of money will be receiveddown the road. How high are thesefees? According to Morningstar Inc,purchasing a stock fund inside a variableannuity will cost you an averageof 2.37% annually of the sum invested.That's considerably higher thanthe 1.58% average of regular stockmutual funds. But Clements cautionsthat not all variable annuities shouldbe judged as harshly. He points outthat both TIAA-CREF and the VanguardGroup offer variable annuitieswith annual costs below 1%.
Apply the Proper Criteria
Clements asks the question, "Doesthis tax deferral really compensate forthe higher investment costs and heftytaxes upon selling?" A lot depends onan investor's time horizon and thealternative investment being considered.To illustrate, Clements cites thecalculations of Baylor University financeprofessor William Reichenstein,PhD, CFA®. If the investment option isan actively managed stock fund or alow-expense bond fund, Dr. Reichensteinsays you'll do better purchasingthe funds inside a low-cost annuity,as long as your time horizon is atleast 20 years.
However, if the choice is between alow-cost variable annuity and a lowcosttax-managed stock fund held in ataxable account, Dr. Reichenstein statesthat the tax-managed fund should winout, because while both the tax-managedfund and the variable annuity willprovide tax-deferred growth, the tax-managedfund will do so at the lowercapital gains rate.
Nevertheless, Clements believes thetaxable account has its drawbacks.First, there's no guarantee that the largegap between the income and capitalgains tax rates will remain. With taxlaws being rewritten every few years,and Congress under pressure to fundboth Medicare and Social Security benefits,that gap could shrink rapidly.Second, a variable annuity offerspotentially greater investment flexibilitythan a taxable account. Clementspoints out that the annuity's tax-deferralstatus allows you to sell winningstocks, rebalance your portfolio,and shift toward bonds as you growolder.