Financial Advice for Retirement, Social Security, IRAs and Estate Planning

New Rules Protect Variable Annuity Shoppers

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Better late than never seems to be a principle of regulators. In that spirit new regulations were issued recently covering the sale of variable annuities.

Variable annuities are one of the most-discussed investment vehicles of the last couple of decades. They have had strong sales, as investors are attracted by mutual fund investments coupled with the tax deferral of annuities.

Yet critics, this newsletter among them, point out that the higher costs and other features make the annuities unattractive for many investors who are buying them. Recently, Raymond James Financial Services was fined almost $3 million for failing to supervise variable annuity sales. Waddell & Reed in 2004 paid a $5 million fine to NASD and agreed to refund up to $11 million to over 5,000 customers as a result of annuity exchanges.

Regulators at the NASD finally issued comprehensive rules governing the sale of variable annuities, and these regulations incorporate many of the points raised over the years. While the rules apply to broker-dealers who sell the products, investors can use them as a good checklist for determining when a variable annuity is appropriate.

The big temptation with variable annuities is that they pay high commissions to brokers. Investors need to be careful that the lure of a commission is not causing a broker to oversell the annuity. The rules also recognize this temptation by requiring multiple reviews of the suitability of a variable annuity before the sale is finalized.

Here are some factors we have emphasized in the past that are reflected in the rules.

Long-term investments. Variable annuities have higher expenses than straight mutual fund investments, and they tend to convert tax-advantaged long-term capital gains into ordinary income. To overcome these effects the investor must hold the variable annuity for a long time. The minimum holding period depends on the annuity’s costs, but the minimum break-even investment period generally is 10 years. Higher cost annuities require longer minimum holding periods.

This means that if the investor is older a variable annuity is inappropriate. Also, if the investor is only a few years short of retirement but will need to begin withdrawals from the annuity as soon as retirement begins, a variable annuity likely is inappropriate.

Tax position. The investor is not likely to need the deferral of an annuity unless he or she is in at least the 28% tax bracket. Also, the annuity is more valuable if the investor expects to be in a lower tax bracket in retirement than during the accumulation years. Distributions from an annuity before age 59½ are subject to a 10% early distribution penalty in addition to income taxes; anyone who might need the money early probably should not purchase a variable annuity.

Annuity lock-ins. Most variable annuities impose surrender penalties or redemption fees if the investor withdraws money without waiting a minimum period. Some surrender penalties expire after seven years; others last much longer. Investors need to fully understand these penalties and their effects.

Other saving options. A variable annuity should not be considered unless the investor already has exhausted other tax-saving investment opportunities such as 401(k)s and IRAs. These have tax deferral and usually charge lower costs than annuities.

Retirement distribution methods. Annuities generally allow several different distribution methods: lump sum, systematic withdrawals, periodic withdrawals, and annuitization. The investor must understand which are allowed under the contract, the details of how they work, and which methods are not allowed.

Lifetime and survivor guarantees. Many investors believe that these guarantees merit the higher costs of annuities, even if they are included in vehicles that already are tax-advantaged such as IRAs. A standard lifetime payout now allows the investor to withdraw 5% of the original investment annually for life, regardless of how the investments performed. But if the investor wants to cash out the annuity in a lump sum, the guarantee does not apply. The investor could receive less than the original principal if the investments did not perform well. Also, the guarantees are only as secure as the insurer making them.

Effects on heirs. When a variable annuity is inherited, it is included in the estate of the owner. In addition, heirs pay income taxes on the accumulated income and gains as they are withdrawn. Therefore, a variable annuity is not ideal for money that is surplus funds likely to be left to heirs.

Investment risk. to offset their higher costs, annuities need to be invested in higher-returning investments. If the investor is risk averse and does not want such investments, a variable annuity probably should not be purchased.

Retirement income needs. An annuity should be part of a full investment package that ensures enough income to pay for basic living expenses in retirement.

Exchanging annuities. Critics believe some of the biggest annuity abuses occur when an annuity is exchanged tax-free for another annuity. Often, the broker earns a sizeable commission on the exchange without changing the investor’s position in a meaningful way. Insurers have to closely monitor annuity exchanges, especially if they extend or restart redemption penalty periods.

Investors who are considering variable annuities can expect to spend more time on the process than some have spent in the past, and that is a good thing. The broker or agent has to document why the annuity is suitable for the investor and also that the investor understands the policy’s features and costs. The purchase will be reviewed by supervisors before it becomes final. In some cases investors might be told that the sale will not be finalized because it is inappropriate.

The new rules provide needed protection for investors, though they come too late for many. They require checklists and reviews by sellers and also supply a good outline of factors for the investor to consider.

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