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  • CFO Magazine

Beware the Fine Print

Despite some welcome improvements, variable annuities still scream ''caveat emptor.''

The web version of this article has been expanded to include the sidebar “Second Time Around,” which did not appear in the March print edition of CFO magazine.

At a family gathering this past Thanksgiving, the head of the household suddenly announced that he was planning to invest in a variable annuity as part of his retirement portfolio. The patriarch started to explain why, but before he could get in another word his son-in-law, a university tax professor, gasped: “Are you crazy?”

Annuities have garnered a bad rap in some circles, and not without reason: from unscrupulous sales tactics to inflexible and potentially costly contracts, annuities have caused some investors a lot of grief.

But that hasn’t dimmed enthusiasm. Over the past 10 years, annual sales of annuities have increased every year, jumping from $74 billion in 1996 to $133 billion in 2005, says trade group NAVA. That’s an 8 percent annual growth rate.

What’s fueling the interest? For starters, most retirement-planning models end at age 85; many people do not. (The U.S. Census Bureau estimates there are currently 5.2 million citizens aged 85 and over.) The promise of a guaranteed lifetime benefit, plus certain tax advantages and potential protection from downside risk, has made believers out of many. Annuities also provide diversification. In fact, Bruce Schmidt, an estate attorney with Howd, Lavieri & Finch LLP, in Winstead, Connecticut, contends that investors should view annuities as a substitute for bonds — assuming they can live with a conservative investment with limited liquidity.

Twists, Turns, Fees

Essentially, an annuity is a reverse life-insurance policy. While a typical insurance policy protects the buyer who might die too young, an annuity protects the buyer who lives too long.

It works like this: A customer pays an insurer a lump sum up front. In exchange, the seller guarantees that customer an income stream over a set period of time — often a lifetime. The insurer is betting that the buyer will die early enough to be financially advantageous to the carrier; if the policy does not contain a death benefit, the insurer keeps what’s left of the principal.

Annuity contracts come in two varieties, immediate and deferred. Immediate annuities begin paying out with the purchase of the policy; deferred contracts pay out some time in the future. The payouts themselves can be fixed or variable. Fixed annuities offer prescribed payments, similar to a traditional defined-benefit pension plan. The payment stream from a variable annuity is based on the performance of an underlying subaccount investment, similar to a mutual fund. Therefore, the payout can end up being greater than first estimated.

One major knock against annuities has been their relative lack of liquidity. An insurer assesses “surrender charges” (typically beginning at 8 or 9 percent and declining each year, but sometimes as high as 25 percent of the contract value) when an investor withdraws some or all of the value before the holding period expires.

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