Variable annuities are and investment vehicle that look attractive in these times of market turbulence. Here’s a look as the advantage and disadvantages of variable annuities.

Variable Annuities And Why They Make Sense
By Thomas Corley

Annuities have so many advantages over other investment vehicles, including mutual funds, that it makes one wonder why everyone doesn’t consider them more often. When you think about variable annuities think about mutual funds on steroids.

Everyone pretty much understands how mutual funds work. The fund managers invest in a variety of publicly held companies, usually with a track record of strong earnings growth or strong earning potential. If the mutual fund sells any of its investments (public company stock) the gains are passed through to their individual mutual fund investors (you and me) and taxed as capital gains. There may also be dividends that the mutual fund passes through to its investors, which, likewise, come from the dividends paid to the mutual fund by the public companies the fund owns.

Annuities are very much like mutual funds in that they too have fund managers who invest in various publicly held companies. However, unlike mutual funds, any gains or dividends realized by the annuity are not taxed to the annuity investors (called “contract owner”). All income and appreciation in the annuity investments grow tax deferred. Annuities are not taxed until the contract owner begins withdrawing money out of the annuity. This allows 100% of the annuity investment to compound year after year, without being reduced by any income taxes.

Tax deferred growth is the main reason annuities are favored over mutual fund investments. There are other advantages as well. Most annuities come with what is called a death benefit. This death benefit is paid to the annuity contract owner’s beneficiary upon death. The very nature of the death benefit provides annuity investors and their heirs with a guarantee of sorts on the annuity investment.

For example, suppose John Smith invests $200,000 in a deferred variable annuity and the next two years the stock market collapses 15%. If John were to pass away shortly thereafter and this money was, instead, invested in a mutual fund, John’s estate would be entitled to only $170,000. If John’s money was, rather, invested in a variable annuity his beneficiaries would receive $200,000, his original investment. You see, annuities make it possible for conservative investors to gamble their money on the stock market, hoping for the big wins, without losing their investment, as is possible in a mutual fund.

Also, many annuities permit the contract owner to lock in the gains they have realized in their annuities by stepping up the death benefit to the value of the annuity at a certain date. For example, suppose John Smith’s annuity investment of $100,000, which included this step-up feature, were to grow to $150,000 at the end of year two but fell to $90,000 in the beginning of year three. Now if John Smith were to pass away shortly thereafter his beneficiaries would be entitled to $150,000, not the $90,000 value at death. If John were invested in a mutual fund his estate would only receive the $90,000 value at death.

More good news. Most mutual funds charge an investor some type of commission commonly referred to as a “load”. These commissions can be as high as 8.5% but typically average about 4%, and for those mutual funds called “A Shares”, this commission comes right off the top of the amount you just invested (”front load”). Thus a $5,000 investment in a mutual fund may mean that only $4,575 ($5,000 minus 8.5%) is going to work for you. So right out of the gate you may have to make a 10% return on your money just to get back to where you began.

The great majority of variable annuities do not charge a commission to the investor. Whenever you invest in any annuity, 100% of your investment goes right to work for you, immediately. When you invest in an annuity, money grows and compounds tax-deferred indefinitely. The only time you pay income taxes is when a withdrawal is made, and you only pay taxes on those withdrawals that are considered accumulated growth or interest, not on monies received that are considered a return of your original investment.

Annuities come in three flavors: fixed, equity-indexed and variable. Fixed annuities are like CD’s on steroids. They guarantee a fixed rate of return and your underlying investment is guaranteed by the insurance company. It is the most conservative annuity investment available. Equity-indexed annuities are fixed annuities whose return is not a guaranteed rate of return but rather a variable one that is linked to an index such as the S&P 500. Equity-indexed annuities seem to have it all: guaranteed minimum contract value, the opportunity to participate in the long-term growth of the stock market, no loss of accumulated earnings (no downside) and no investment decisions to make. Indexed annuities are fast becoming the annuity of choice to conservative investors who are not satisfied with the conservative returns offered by their pure fixed annuity brethren.

Variable annuities are the celebrities in the annuity family. They are the glamorous cousins to the fixed and index annuities. For all of the reasons mentioned above, variable annuities are the true kings of the annuity world. They offer variety, security, upside potential, limited downside risk and a way to pass along your estate to your heirs without having to go through the difficult probate process. Variable annuities offer those investors previously burned by the stock market, the ability to jump back into the market without the worry of losing money it has taken them a lifetime to accumulate. In a variable annuity you truly get to have your cake and eat it too!

Tom is a Certified Public Accountant, a Certified Financial Planner, CLTC (Certified Long-Term Care) and President of Cerefice & Company, the largest CPA firm in Rahway, New Jersey. Tom works with clients helping them manage their money, retirement planning, college savings, life insurance needs, IRAs and qualified plan rollovers with an eye towards maximizing tax benefits and minimizing taxes. Tom is founder of the Rich Habits Institute and author of “Rich Habits.”

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