How to Find Lower-Cost Annuities

Variable annuities, one of the few legitimate tax shelters preserved under tax reform, can be a great way to invest in stock and bond mutual funds while deferring taxes on the earnings. Unfortunately, high fees and expenses on many of them wipe out most or all of their tax advantages.

But thanks in part to investor concerns, lower-cost annuities are becoming more common. And thanks to new disclosure rules imposed this month by the Securities and Exchange Commission, you can more easily spot them.

The new rules, which took effect May 1, require prospectuses for variable annuities to disclose sales fees, annual management fees and other expenses up front in a table similar to that now found in mutual fund prospectuses. Until now, such information was frequently scattered throughout annuity prospectuses or was obscured in legalese.

The rules recognize the potential growth of variable annuities as tax shelters on a par with individual retirement accounts. Annuities, offered by virtually all life insurance companies, allow you to invest a certain amount up front, either in one single payment or a series of payments. In return, you or a beneficiary are promised payments in later years, drawn from the investment earnings.

The tax advantage stems from the ability of your investment earnings to escape taxes until withdrawn, just like with IRAs. This tax-deferral benefit allows your investment to grow larger and faster than if earnings were taxed each year.

Also, with an annuity you can invest far more each year than the $2,000 annual limit on contributions to IRAs. Some insurers, for example, allow you to invest as much as $1 million a year or as little as $1,000. (On the other hand, annuity contributions are never tax deductible, whereas IRAs are for some people.)

There are, however, trade-offs for these tax benefits. For one, you must pay a 10% penalty on untaxed amounts you withdraw before age 59 1/2. Also, if you close the annuity prematurely, you may be charged surrender fees that typically start at between 5% and 8.5% in the first year of the annuity and decline each year thereafter until they vanish, usually after five or six years.

Even with such restrictions, annuities can still be an attractive retirement savings vehicle, as long as you’re willing to forgo access to the money for many years.

If you choose a variable annuity, you can invest in stock, bond or money market mutual funds managed by the insurer. You may be allowed to switch between funds if you think stocks will do better than bonds, or vice versa.

Variable annuity funds, however, can decline in value. Such was the case in the 1987 stock market crash, when declines in stock funds hurt sales of variable annuities, prompting many investors to choose fixed annuities instead.

With fixed annuities, the insurer invests your money for you in fixed-income investments. The value of your fixed annuity grows at interest rates set by the insurer each year.

If you are a more aggressive or sophisticated investor, you’ll probably prefer variable annuities. The problem with them, however, has been high fees and other charges, often used to pay sales commissions, administrative charges or death benefits.

Annual expense ratios--charges as a percentage of assets--average about 2% on variables, double that of typical no-load mutual funds (those without up-front sales charges) not in annuities, says Glenn Daily, insurance product analyst at Seidman Financial Services in New York.

Such higher expenses can add up over time and easily wipe out the tax-deferral advantages of annuities, making no-load mutual funds a better bet in many cases, Daily says. He notes that taxes on capital gains in mutual funds in effect also are deferred as long as the underlying stocks or bonds are not sold.

Concerned about high fees, insurers such as John Hancock have recently rolled out annuities absent of both sales and surrender charges.

The new SEC disclosure rules should help you detect these and other low-cost annuities.

With the rules, you can hold prospectuses for variable annuities and mutual funds side by side and compare fees over time. Annuity prospectuses, like those for mutual funds, now must show total expenses you would pay at the end of one, three, five and 10 years, assuming a $1,000 initial investment and 5% annual return.

What should you look for in expenses?

Rick Carey, president of Financial Planning Resources Inc., a Miami firm that evaluates variable annuities, says annual administrative fees and so-called mortality and expense fees should not exceed between 1.25% and 1.5%. Annual investment advisory fees should generally not exceed 0.75% for annuity stock funds, 0.30% for annuity money market funds, and 0.60% for fixed-income funds. Annual maintenance fees should not exceed between $20 and $30.

Carey also suggests looking for annuities that allow you to switch between funds by telephone. Some insurers also allow you to switch between fixed and variable annuities.

Most important, choose variable annuity funds with strong performance track records, particularly ones that achieve consistently good returns without incurring excessive risk. However, performance for many variable annuity funds has been less than sterling.

Last year, for example, variable annuities invested in stocks posted a 12.98% total return (dividends plus stock price appreciation), according to Lipper Analytical Services. That trailed the 14.47% return for general stock mutual funds held outside of annuities.

Hopefully, performance will improve as more insurers tap successful mutual fund managers to run their annuity funds.

One service that could help you evaluate annuities is the Variable Annuity Research & Data Service, provided by Financial Planning Resources in Miami. It offers performance data, fee and other information on more than 300 variable annuity funds. However, it’s expensive, costing $149 for one quarterly issue. Get a free sample by writing P.O. Box 161998, Miami, Fla., 33116, or calling (305) 252-4600.