If the declining market has diminished your tolerance for investment risk, you are a prime target for variable annuity salespeople. Market volatility commonly influences investors to pay the high fees associated with variable annuities for the perceived safety offered by these complex investment vehicles. Before buying, take time to understand features that salespeople may not discuss.

Annuities 101

Variable annuities enable investors to defer taxes on investment gains until money is withdrawn. Additionally, variable annuities have a death benefit guaranteeing the beneficiary a specified amount - usually the amount invested - upon the investor's death. For a fee, most annuities offer "living benefits" guaranteeing a rate of return (usually 2 to 5 percent) over time. Upon withdrawal, payment can be taken as desired, or converted into a fixed periodic payment. Funds withdrawn before age 59½ suffer a 10 percent penalty. For more information, visit the SEC's website at www.sec.gov/investor/pubs/varannty.htm.

Unfavorable Tax Treatment

Investments in taxable accounts are taxed at capital gains rates, currently between 0 and 15 percent. Annuity gains are ordinary income, currently taxed between 10 and 35 percent. Perhaps the biggest drawback of variable annuities is the lost tax benefits upon the investor's death. Most investments receive a "step-up in basis" that eliminates or drastically reduces the taxes heirs must pay when selling inherited assets. Annuities don't receive a step-up in basis so heirs must pay taxes on the difference between the investment's cost and current value.

High Expenses

Annuity salespeople are commonly paid an up-front commission ranging from 5 to 10 percent. Consequently, upon the sale of a $100,000 annuity, the salesperson receives as much as $10,000 up-front and has no financial motivation to ensure the client's satisfaction after the sale. Although the purchaser doesn't pay the salesperson directly, the insurer charges the investor high recurring fees to recover this expense. Additionally, separate hidden recurring fees are charged by both the insurer and the underlying funds. After adding the cost of living benefit riders to the contract, fees often exceed 3 percent per year. Comparatively, according to Morningstar the average domestic mutual fund charges 1.35 percent.

Surrender Charges

Another consequence of high commissions paid to salespeople is the attachment of a surrender charge to annuity policies. Surrender charges discourage investors from withdrawing funds before the insurer recovers the commission paid to the salesperson. This charge usually starts at 7 to 15 percent and commonly declines over 5 to 15 years.

Living Benefits Not Beneficial

Many living benefit programs require the investor to hold the investment for at least 10 years to achieve the guaranteed rate. There has been few times when a balanced portfolio of stocks and bonds didn't return at least 5 percent annually over a ten-year period. In fact, it took the stock market only eight years to recover during the Great Depression. Also, these guarantees are dependent on the insurer's financial stability. Recent trends suggest insurers may not be able to pay guaranteed rates amid market volatility.

The Bottom Line

Annuities are appropriate for specific circumstances, such as leaving assets to qualified charities or providing extremely risk adverse investors with guaranteed income. If you believe an annuity would serve your purpose, it's time to learn a well-kept secret: you can purchase an annuity without funding a salesperson's vacation. No-load (no-commission) annuities commonly charge less than half the recurring fees of loaded annuities and have no surrender charge. No salesperson is going to discuss this option. A fee-only financial advisor who isn't influenced by commission-based compensation can provide an objective opinion on whether an annuity is a wise investment and direct you to a no-load product.

Lon Jefferies is an investment advisor representative with Net Worth Advisory Group, a fee-only financial planning and investment advisory firm in Salt Lake City, Utah. He specializes in developing custom financial plans, implementing investment strategies, and providing ongoing support and service in order to help clients reach their financial goals. He can be contacted at (801) 566-0740 or lon@networthadvice.com. Visit the Net Worth Advisory Group website at http://www.networthadvice.com and read Lon's blog at http://www.utahfinancialadvisor.blogspot.com

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