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Gimme Shelter

The recent tax hike sent top-bracket investors running for cover. Many found protection under flexible, tax-deferred variable and fixed-dollar annuities.

The insurance industry’s smart guys already had spruced up that stodgy old product, the annuity, before Congress catapulted upper-bracket personal tax rates skyward this past summer. The tax change sent affluent investors running for cover and added several megatons to what had been described by analysts and financial planners as the annuities explosion.

Annuities aren’t for everyone. Fees are stiff, and early withdrawals of investments generally incur surrender charges. In addition, though you may buy an annuity from an insurance company and pay premiums for it, it’s important to remember that it is not an insurance policy. An annuity is income tax deferred-you or your beneficiaries are taxed when your annuity pays off. No tax would be due if you had bought an insurance policy instead, unless your estate is over $600,000 as an individual or $1.2 million as a couple.

Even so, for many investors, the benefits of annuities loom large. What’s more, outstanding stock plays exist among the insurance companies that are chalking up big numbers on annuity sales (see sidebar). Indeed, commenting on the new legislation, The Wall Street Journal said, “The official name of the tax law is the Omnibus Budget Reconciliation Act of 1993, but it might have been called the Annuity and Insurance Sellers Act.”


Simply defined, an annuity is a contract under which an investor agrees to make a series of payments over a period of time for a fixed number of years or over an entire lifetime. Payouts at scheduled intervals-generally monthly, quarterly, annually, or semiannually-begin when an annuitant reaches a certain age. For individual investors, the most common annuities are fixed-dollar annuities, guaranteeing repayment of invested principal plus interest; and variable annuities, which pay based on the capital appreciation of a portfolio.

The primary selling point of annuities remains their tax-deferral advantages, which were established during the Reagan years. All interest income, dividends, and capital gains compound internally, free from federal, state, and local taxes until withdrawal. So far in 1993, sales of fixed-rate individual annuities are up about 20 percent year-on-year, while the sale of variable annuities has jumped a whopping 70 percent. When the dust clears this year, variable sales will comprise roughly one-third of the $75 billion in total sales.

But besides the search for a tax shelter, the annuities boom reflects the fact that many investors are taking retirement planning into their own hands. With good reason. More than a few corporations have folded in recent years, failing to meet their pension fund commitments. We’re bombarded almost daily with predictions that Social Security won’t be adequate even if it’s still around. In this context, management guru Peter Drucker argues that retirement planning will be one of four major new industries over the next several decades.

Some insurance companies have enlisted such mutual fund companies as Templeton, Scudder, Fidelity, Dreyfuss, Lord Abbett, and Oppenheimer to make investment decisions on many of their variable annuity portfolios. In general, the results have been impressive. Under most annuities contracts, investors may shift their money among subaccounts without incurring fees or penalties; for example, from a high-yield bond fund to a small-cap growth fund.

With taxes deferred, the retained rate of return for a variable annuity may substantially exceed that of a mutual fund-particularly if an investment is left untouched for an extended period. An investment of $50,000 in a mutual fund that earned a steady 7 percent a year would grow to $128,434 in 20 years if taxes were deducted each year at 31 percent. The same amount in a variable annuity would grow to $193,484, about 50 percent more.

Annuities are a popular way for a corporation to fund deferred compensation packages for senior executives. Depending upon circumstances, such as the existence of qualified retirement plans, the plan may defer up to 15 percent of an executive’s compensation package up to 15 percent of an executive’s compensation package up to $200,000 a year. Annuities also can be used to accumulate money for a specific purpose, such as funding the education of one’s child or grandchild.


Annuities pay out in a variety of ways: The most popular options are lump-sum payments and fixed, monthly payments calculated to run until the death of the holder or, if desired, until the death of the holder’s spouse. But payments also can be tied to investment performance or to the level of inflation, or structured to take into account current or future sources of income. Under a so-called immediate annuity, the annual payout is based on age: A 65-year-old investor might receive a 9 percent rate of return, while a 75-year-old gets 12 percent or more. Other bells and whistles include long-term care provisions with increased payouts in the event of disability.

Caveats abound. While fees and management performance fluctuate wildly, the average variable annuity hits you with a 2 percent annual charge, plus an additional fee of at least $25 for record keeping and maintenance. On a $10,000 investment, that means an additional 0.25 percent hit. The fees get particularly onerous in the event of a bad year for a variable portfolio. While a 2 percent fee takes a substantial chunk out of an investment earning 10 percent, it may gobble all or nearly all of a return in the lower single digits.

Also beware of surrender penalties, though with both fixed-rate and variable annuities, these penalties disappear if the policy is held for a specified number of years. Normally, the surrender penalty ranges from 5 percent to 10 percent during the first year, with the penalty declining a percentage point each additional year the annuity is held. Keep in mind, however, that with qualified retirement plans such as IRAs, the government’s 10 percent penalty for early withdrawal never disappears.

A final disadvantage: When placed in trusts, donated to charities, or passed on through an estate, there is no clear rule of thumb on how annuities will be taxed. In fairness, however, there isn’t an investment that hasn’t encountered trouble under such circumstances.


Before proceeding with an annuity purchase, investors should seek advice from a financial adviser, broker, accountant, attorney, or hanker. But another source of information on annuity performance-particularly for “do-it-yourself’ investors-is independent rating agencies. Morningstar publishes monthly reports analyzing variable annuity percentage gains and losses for all portfolios. Results differ, particularly when funds concentrate on differing market sectors; for example, small-cap foreign companies, high-tech growth stocks, or high-yield bonds. Similarly, A.M. Best publishes the credited rates for fixed-rate annuities, and the fee structures for all annuities, fixed and variable.

Do your homework. Check the alternatives. But we’re betting that annuities will stack up well against other retirement products and tax shelters.

One thing is certain: Under a tax-and-spend administration bent on “fairness” and income redistribution, annuities are looking better all the time.

Ray Dirks is the founder of Ray Dirks Research, a division of New York-based brokerage RAS Securities.

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