To hear a salesman tell it, you would think that annuities are the last of the great tax shelters. The truth is that the tax benefits are oversold, disappointing, and may be negative for most investors. It’s true, annuities receive different tax treatment under Federal Law. All types of income are deferred on gains made inside the contract. This allows long and short term gains as well as interest and dividends to compound free of current taxation. 

That’s the good news. But, the other news isn’t at all good. 

Gains that might otherwise have been capital gains are converted to ordinary income when withdrawn. This effectively doubles the tax upon liquidation or withdrawal. Under current tax rules, withdrawals are first considered income and not until all gains are withdrawn can basis be recovered. Investments in annuities may be locked up for extended periods because any withdrawals prior to age 59 ½ are subject to penalty tax of 10%. Finally, annuities are one of the few assets an investor could own that are subject to income tax at death. So, while much is made of the tax advantages of annuities, on balance, annuities are un-favorably taxed compared to other alternatives.

For instance, an investor that purchased a no-load mutual fund total market index would have almost all the benefits of deferral, capital gains treatment upon sale of shares, no tax penalty for early withdrawal, and forgiveness of any capital gains at death (step up in basis). In addition, if he sells part of the holdings, he is entitled to prorate his capital gain and return of principal for each block of shares. The index fund wins hands down for tax efficiency.

Along the way he probably would save about 2.0% per year in annual expenses, a tremendous benefit in itself.

Mortality assumptions

During the payout phase, an insurance company annuity can incorporate a mortality assumption that allows it to spread out (amortize) the principal over the annuitant’s projected lifetime. Because each payment includes both earnings and a return of capital, the payment can be larger than if the payment were earnings only.

That’s the theory, but in practice the extra costs eat up any theoretical advantage. Even if we thought that there might be an extra lifetime income, there still is a pesky problem: at the death of the annuitant, the insurance company simply confiscates the remaining capital. The insurance companies may like the idea of inheriting your capital, but your other beneficiaries might be forgiven for preferring some other distribution arrangement.

An income you can never outlive

The other claimed advantage of an annuity contract is that it can provide a guaranteed income that you can never outlive. This grossly overstates the case. How the contract will work in practice depends on whether it is fixed or variable.

Fixed annuities are generally sold and the benefits calculated based on “current” credited interest rates. However, the contract guarantees only a lower interest rate, usually in the four to five percent range. Pressure from sales and marketing to illustrate high current rates results in wildly inflated assumptions. In fact, once the investor purchases the contract surrender charges effectively lock him/her in, and they find themselves held hostage to the tender mercy of the insurance company. So, of course, the insurance company lowers the credited rate whenever rates fall across the economy. The investor is in the same position he might have been if he had decided to live off the interest from a CD. When rates fall, so do renewal interest rates. But, in this case, the investor has no graceful way out.

The spectacular failure of this model over the last twenty years of falling interest rates is well documented. Income rates fell dramatically. Many policy holders found their income shrinking by more than fifty percent of the illustrated amounts. Worse yet, existing policyholders often found that their credited rates were below rates being promised to prospects or holders of newer contracts. Several large companies collapsed, the most prominent being Executive Life of California, and policyholders were left serious capital depletion as well as reduced income.

Variable annuities promise an income for life, but they don’t promise any particular amount. One dollar per month would satisfy the contract requirements. The first month’s payment is calculated based on an assumed earnings amount.  Thereafter, the entire payout is based on future earnings of the various separate accounts. Poor investment results will result in ever decreasing income to the retiree. In this respect, the investor is no better off than if he calculated a fixed percentage withdrawal from a mutual fund portfolio. There is no floor or guaranteed minimum payment included in any variable annuity contract.

Summary

The two big selling points of annuities, tax advantages and lifetime income turn out to be grossly overstated. They just don’t stand up to close scrutiny.

Next: In search of a graceful exit strategy. If you have an annuity already, are you stuck? Can you dodge the twin bullets of taxes and surrender charges?

Frank Armstrong, CFP, is the author of Investment Strategies for the 21st Century, published here, President of Managed Account Services, Inc., a fee-only Registered Investment Advisor, and Chief Investment Strategist of DirectAdvice.com.

Note: The featured writer is solely responsible for the content of this article. The opinions expressed herein are not necessarily those of MFI or BES, Inc.

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