The Portfolio Reporter – Annuity Supplement

A Newsletter Provided by John F. Towson • Insurance and Financial Services

Is an annuity right for you? Do you feel as though you are accelerating into retirement with no way to avoid the inevitable? Are you in retirement and concerned that you may outlive your retirement portfolio? If the answer to any of these questions is yes, then an annuity may be the emergency brake you have been looking for.

Many of us have heard that annuities are expensive and should be avoided. Though propagated by the media, this myth is rarely supported. Most comparisons with mutual funds neglect to include the associated costs of owning mutual funds, such as annual taxation and a possible increase in probate fees. Annuities avoid both of these costs.

The argument against annuities stems from three of their characteristics: surrender period, increased commission, and tax penalties. The surrender period is a set length of time, usually 5 to 10 years, you are required to keep a minimum amount of money in the annuity. However, most contracts enable you to withdraw up to 10% of the value of the annuity annually, without paying a surrender charge. Surrender charges vary, but they normally start at 7% and decline as the end of the surrender period approaches. Second, the sales commission is normally greater for annuities than for other financial products and can range from 5-6%. Third, a tax penalty of 10% is applied to the withdrawn amount if you are below the age of 59½. This penalty is in addition to the ordinary income tax on the amount withdrawn and any applicable early surrender charge. Therefore, annuities may not be appropriate for investors who believe they will withdraw their money before the stated surrender period or before the age of 59 ½.

Annuities are especially beneficial if any of the following apply:

1) You have exceeded the amount of money you can put in other qualified tax deferred plans such as a 401k, a 403b, or an IRA. 2) You are concerned that the stock market may decline in the future. 3) You would like to provide a benefit to your spouse or survivors in the event of your death.

Some annuities have fees that are higher than mutual funds, but for those fees you can expect to receive additional services and benefits not included with a mutual fund, such as insurance and guarantees against loss of principal*. Overall, this can create variable annuity costs that are one to two percent higher on average than those of a mutual fund. On the other hand, however, an investor also must consider the implicit cost generated from short- and long-term taxes on mutual funds. First, mutual funds with high turnover create short-term gains that are taxed at higher effective tax rates. Additionally, the gain on the sale of a mutual fund is taxed at a long-term capital gains rate now at 15%, while the deferred income from an annuity may be taxed at an effective rate that can be kept in the 15% range for most retired people. The most compelling benefit of an annuity, however, is that your income grows tax-deferred.

One may view the argument in favor of annuities as paying more to receive greater value. Consumers do this all the time, especially when buying an automobile. Take, for example, the Ford Escort. Consumers buy this car because it has a radio, air conditioning, and the ability to get from point A to point B economically. Other people, however, purchase Lincoln Town cars that have plush leather seats, navigation devices, and TV/DVD players because they appreciate the value of these accessories and are willing to pay more for them. Likewise, if you value deferred taxes, death benefits, and an annuitization plan, then annuities will provide you additional value over mutual funds.

Future events may change the value that annuities provide. President Bush’s tax plan proposes an increase in the amount of money that may be deposited into a 401k, a 403b, or an IRA. This will reduce the dependence on the deferred tax advantage that annuities provide. Furthermore, annuity companies that have, until recently, allowed investors to take advantage of a guaranteed return, in most cases about 3% annually, have increasingly, discontinued this benefit because it is too costly for annuity companies.

BENEFITS

Annuitization is defined as the exchange of a lump-sum payment for a stream of periodic payments in the future. Payments may continue for a specified period, or for life. Once payments begin, they are not tied to the value of the stock market (with the exception of some variable annuities). This protects your portfolio from downfalls in the market such as we have seen over the last three years. Further details would be located in the offering material, which should be reviewed carefully.

The death benefit comes in many shapes and sizes. The basic benefit provides beneficiaries the full value of the original contributions, even if the stock market reduces that value. For example, if you had invested $100,000 in an annuity in 1997, and the underlying value declined 20% (to $80,000) today, your beneficiaries would receive the $100,000 (less any withdrawals), while the mutual fund beneficiaries would receive only $80,000. In addition, if you are concerned about a potential decline in the stock market, some annuities have a guaranteed minimum income benefit or increasing death benefits, which is basically an insurance policy that guarantees that you will have the value of the original investment less any withdrawals plus a set rate of return after a certain length of time. For example, a variable annuity may guarantee an annual increase of 6% or may ratchet up the value of the annuity equal to the gain in the stock market. Under the guaranteed plan, if you invested $100,000 in an annuity and died a year later, then your beneficiary would receive $106,000. The ratchet clause provides an explicit return on capital each year or states that when your account appreciates a certain amount, the value of your account cannot decline below that amount. Therefore, with the ratchet-up plan, if a $100,000 portfolio increases 11% over a year (to $111,000) and then declines 15% (to $94,350), your beneficiary would receive $111,000, because the ratchet-up plan guarantees the highest value of your portfolio, even if it has since declined in value.

These additional benefits are certainly not included in a mutual fund, they are worth more to some investors, and in many cases they justify the higher fees charged to one who seeks this type of investment.

We realize that you may not need or appreciate the value-added benefits of an annuity over a mutual fund. To help you evaluate how you could benefit from an annuity, we recommend the following: 1) review your taxes; 2) insure you have fully funded your deferred savings plan (IRA, 401k, 403b); 3) determine your preference/need for a consistent revenue stream during retirement; 4) determine whether you want to guarantee the principal you would like to pass to your beneficiaries; 5) speak with your financial advisor to see if an annuity is right for you.

Newsletter published by Jamie Cornehlesen and Dunn Capital. The opinions expressed here are based on the author’s views and should not be construed as financial advice. For more information about your investments, please contact your financial professional Please feel free to pass the “Portfolio Reporter” to interested friends and family members. Special thanks to John P. Huggard, J.D, CFP, who helped us edit this article.

* As with all annuities, guarantees are based on the claims paying ability of the insurer and do not apply to investment options; are NOT insured by FDIC or Any Federal Government Agency; may lose value; are not a deposit of or guaranteed by any bank,, Read the prospectus/offering material carefully before sending money.