Variable Annuities: A Steady Income Stream, but First Read the Fine Print
As you plan your retirement investment portfolio, does the idea of a financial product that provides a guaranteed monthly payout, no matter how long you live, sound appealing? If so, you might want to consider buying an annuity.

But first make sure you understand the details.

An annuity is essentially an insurance product that can grow indefinitely on a tax-deferred basis, but which has the ability to provide a steady income stream when you reach the retirement years.

In other words, they are investments that grow in value over time, but which pay regular dividends once they are "annuitized." Unlike an IRA or 401(k), annuities are designed for people (over the age of 59 1/2 ) who want their money to grow but are more concerned with receiving regular payments they can use to cover living expenses than watching their investment continue building value for a future cash out.

Annuities come in two principal forms: fixed and variable.

Fixed annuities pay a fixed rate of interest, similar to a CD or bond. Variable annuities, on the other hand, are market-oriented investments whose fortunes rise or fall depending on the value of the stocks, bonds or money market funds in which they are invested. While a variable annuity adds an element of risk, it stands to yield higher gains than its more conservative "fixed" cousin.

Variable annuities work in two phases - an accumulation phase and a payout phase. As Kevin Gahagan, a certified financial planner with Mosaic Financial Partners in San Francisco, explains, they are "a hybrid between an IRA and a pension fund." During the accumulation phase, the annuity works like an IRA in that contributions are allocated into different funds, called subaccounts, and earnings grow on a tax-deferred basis.

But unlike IRAs, when funds are taken out of a variable annuity at before age 59 1/2, they are subject to a tax penalty of 10%. However, if earnings are annuitized during this "payout" phase, the annuity works like a pension, in that it provides periodic income, which can be structured to last for an investor's lifetime, a joint lifetime (with a beneficiary) or for a fixed term of years.

One of the biggest selling points for a variable annuity, according to Gahagan, is that the investor is virtually guaranteed at least the amount of money invested in the product until its annuitization, regardless of its eventual account balance. For the more cautious investor, the prospect of a reliable income stream over an indefinite period may mean many nights of better sleep. Other benefits include:

  • Tax deferred earnings - the investor pays no taxes on the annuity's earnings until they start making withdrawals.
  • Death benefit - when the investor dies, his/her designated beneficiary is guaranteed to receive at least the sum of all premiums paid, minus any loans, surrender charges or withdrawal fees (see below).

But before investing in variable annuities, it is important to understand their complexities and limitations. These include:

  • Fees for early withdrawals - withdrawals made before the investor turns 59 1/2 are subject to 10% tax penalty, as well as a tax on gains, which are regarded as ordinary income.
  • Surrender charges - if a variable annuity contract is terminated before a specified period of time (typically five to seven years), the investor must pay a "surrender charge" of as much as 10%. Furthermore, Gahagan warns, if funds are withdrawn before they are annuitized, they are subject to the "last in, first out" rule, whereby the last dollar in to the annuity is the first to be taxed. Since the last dollar that went in was interest, it is taxed as ordinary (high) income.
  • Other expenses - such as administrative fees, fund charges and annual fees for principal protection, which can take at minimum 1.4% off the top of the investment's value.

So given these complexities and potential downsides, is there a place for variable annuities in an investor's retirement portfolio? Gahagan believes so, if they are part of a broader portfolio that includes fully maximized 401(k) or IRA plans, and if they are used for their original intended purpose, which is in providing a lifetime income stream.

He recommends that potential investors do their research, and discuss the appropriate role of variable annuities in the retirement portfolio with their financial planner, particularly as new products are being developed to address issues of current concern.

For investors who have decided to purchase a variable annuity, Gahagan advises that they shop around to compare features and associated expenses of competing produces, and to be sure they understand the following:

  • how the variable annuity works, and the benefits it provides.
  • the fees and expenses associated with the annuity.
  • the risk of a loss in value of the investment over time.
  • the commission charged by the broker for sale of the annuity.
  • the effect of annuity payments on tax status.

Kevin Gahagan is a partner, certified financial planner (CFP) and certified investment management analyst (CIMA) with Mosaic Financial Partners in San Francisco, where he specializes in advanced financial planning for individuals. He is an instructor at the UC Berkeley Extension School, and sits on the board of the Estate Planning Council of Diablo Valley.

For more information about annuities and other investment options, see www.MyMoney.gov, the U.S. government's website dedicated to teaching all Americans the basics about financial education. The Federal Citizen Information Center also provides information about annuities.

 

(This article appeared in the Spring 2006 issue of Bay Area Summit)

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