Annuities: Are Low-Cost Annuities A Good Choice?

I've disliked variable annuities for many years because of their high fees and onerous surrender penalties. Now, low-cost variable annuities are available that slash fees and do away with the surrender penalties. Does this change my opinion on the use of variable annuities? Read on to find out.

There is $1.8 trillion dollars invested in annuities and a lot of that money is in variable annuities. To put this in perspective, there are $2.1 trillion in 401(k) assets. That's right. There's almost as much money in annuities as there is in 401(k) retirement programs!

As I've mentioned in previous articles on variable annuities, variable annuities are sold because of two main features--tax deferral and a death benefit guarantee.

Tax-deferral is emphasized if you are investing non-retirement money. Instead of having to pay taxes on dividends, interest and gains each year, those taxes are deferred until you withdraw the money from the annuity.

This used to be an attractive option, but not since capital gains and dividend tax rates have been lowered to a maximum of 15%. You see, earnings withdrawn from an annuity are taxed at higher ordinary income rates. These can be as high as 33%.

In years past there wasn't much difference between ordinary income tax rates and those on dividends and capital gains. Now, there is a substantial penalty when earnings are taxed as ordinary income. As a result, it can take decades before you really see the benefit of tax-deferral.

The other main selling point of variable annuities is the death benefit guarantee. Investors like the peace of mind knowing that even if the market drops substantially, their heirs will get at least what they initially invested when they pass away. This is used to entice investors to choose an annuity for their IRA where the annuity's tax-deferral feature is worthless.

Unfortunately, investors had to pay through the nose for those benefits--typically 1.4% of the value of your account each year. On a $200,000 account, you would be paying $2800 a year. Over ten years it is likely those benefits would cost over $30,000. That's some of the most expensive insurance you will ever buy.

Now there are new, low-cost variable annuities available from companies like Fidelity and Vanguard that lower the costs of these benefits. For instance, Fidelity offers one that charges 1/4% in fees each year. That's 1.15% less each year then the typical variable annuity. The Fidelity variable annuity still offers the much touted benefit of tax-deferral but it does not offer the death benefit guarantee.

If the death benefit is the main reason you want a variable annuity, you can achieve that goal with the Fidelity variable annuity by purchasing a separate term life insurance policy. Doing so would save a 60-year old non-smoking man almost $15,000 over ten years versus the typical variable annuity.

As investors age, these savings decrease. But even then, you have to realize that your 'guarantee' is actually much higher with a private life insurance policy than it is with the broker-sold variable annuity. In the broker-sold variable annuity, your either get the market value of the contract OR the death benefit, whichever is higher.

When you buy a low-cost variable annuity and a separate life insurance policy your heirs receive the market value of the annuity PLUS the death benefit of the life insurance policy. Even if the annuity loses half of its value, your heirs still end up with 50% more than the broker sold annuity. So even if it costs the same it is still more benefit. And you can keep the insurance policy even if you cash out your annuity.

The only situation I would recommend a low-cost, no surrender penalty variable annuity is if you currently have non-retirement money in a high-cost variable annuity and you have amassed a significant gain. Even if you have surrender charges, it may be worthwhile--see how many years it would take to make up the difference.

For everyone else, I still do not recommend it. If you have IRA money in an annuity, I suggest a non-annuity IRA when your surrender penalties end. You can achieve the same benefits for far less cost.