annuity

HICKS & ASSOCIATES, CPAs

The following article was written by Scott Burns, The Financial and Investment writer for the Dallas Morning News.

Does it ever make sense to invest in a variable annuity?

What would a serious, objective party say?

I went to William Reichenstein, a professor of finance at Baylor University in Waco, Texas, for the answer. Reichenstein specializes in investment and taxation issues for individual investors. A recent paper, soon to be published in Financial Services Review, walks us through a series of qualifying/disqualifying questions. Let's follow them.

First: Are you saving to meet pre-retirement needs?

If the answer is yes, forget variable annuities. Reichenstein says you should be saving in a taxable account. Withdrawals before age 59 1/2 from non-qualified annuities, Roth IRAs or deductible pensions are usually subject to a 10 percent penalty.

Second: Are you saving to meet post-retirement needs?

The best choices are deductible pension accounts such as 401(k) accounts, IRA accounts and Roth IRA accounts. Savers, he says, should look elsewhere only when they have taken full advantage of these accounts.

With 401(k) contribution maximums rising to $15,000 a year by 2006 and "catch-up" provisions for people 50 or older starting this year, most workers can defer more income than they can put aside. This year the limit is $12,000 per 401(k) and $3,500 for a Roth IRA, a total of $15,500 per person. That's $31,000 per couple.

Reichenstein notes that each spouse in a married couple over 50 will be able to contribute $20,000 to a 401(k) plan by 2006 plus $6,000 to a Roth IRA. That's a total of $26,000 per worker, or $52,000 per couple.

Whether the limit is $31,000 or $52,000, it's way beyond what most people save.

Third: Suppose you have "maxed out" on a Roth IRA and 401(k). Should you save in a taxable account or in a non-qualified variable annuity?

Here, Reichenstein offers a single guide, "Expenses matter."

"Look," he said in a recent interview, "we know that we'll earn 5 percent on a high-grade bond portfolio. You have an average expense ratio of 2.0 percent in bond funds in variable annuity accounts. ... So the expense is the equivalent of a 40 percent tax rate, and the 3 percent retained is only tax-deferred.

"Now compare that to a low-cost bond fund. You'll earn 3.4 percent after fees and taxes. That clobbers 3 percent, tax-deferred."

While few comparisons are as telling, Reichenstein examined the impact of expenses on average annuities, low-cost annuities, average-cost mutual funds, low-cost mutual funds and low-cost index mutual funds. Here is what he found:

Low-cost annuities and low-cost bond funds provide more after-tax income than average-cost bond fund annuities in all accumulation periods.

Average-cost bond funds beat average-cost annuities in all accumulation periods when interest rates were at 5.5 percent. They trailed average-cost annuities when interest rates were 8 percent and the accumulation period was 20 years or more.

Low-cost annuities beat low-cost active stock funds over long periods and during periods of high returns.

Average-cost annuities beat average-cost, actively managed equity funds when the accumulation period was more than 10 years. They never beat a low-cost, actively managed stock fund or a low-cost index fund. A low-cost index fund did better than a low-cost annuity.

What does all that mean?

Very simple: The logical market for tax-deferred annuities is very small.

Does creditor protection make a difference?

Some. Assets in qualified plans are protected from creditors. Creditor protection for annuities and IRAs, Reichenstein points out, varies from state to state. As a result, creditor protection is a possible benefit. But it is not a unique "clincher."

What does this mean for you and me?

Reichenstein said it very clearly in a paper written for the Journal of Investing. "The evidence ... indicates that non-qualified annuities are either grossly oversold or purchased for non-investment reasons."

Want to read his research? Visit http://finance.baylor.edu/reichenstein and click on "research."

(Questions about personal finance and investments may be sent to Scott Burns, The Dallas Morning News, P.O. Box 655237, Dallas, TX 75265; or by fax: (214) 977-8776; or by e-mail: scott@scottburns.com. Check the Web site: www.scottburns.com. Questions of general interest will be answered in future columns.)

Always remember tax matters can get very complicated. If at anytime we can be of service in your tax planning or the completion of your tax return please let us know.

Best Regards Joe H. Hicks Jr. CPA