Illustrations by Jonny Mendelsson
"The planners who are excited about annuities are in the commission business," asserts Birmingham, Alabama, advisor Stewart H. Welch III. "I'm well-connected with other fee-only advisors around the country, and I'm not hearing any of them saying, 'I've got a really great idea for using an annuity.'" If one area of financial planning crystallizes the fee-versus-commission controversy, it could be VAs. Variable annuities are the hippest thing with broker-oriented planners, selling like hotcakes, but they're anathema to the fee-only crowd.
Or at least they have been historically.
Now, thanks to low-cost products from TIAA-CREF and others (see "," July 1999 Investment Advisor), plus the emergence of (what else?) Web sites that hawk VAs, one of annuities' chief drawbacks - cost - is beginning to go by the wayside. Moreover, today's variable annuities have better features and options than their predecessors. "As products change, that's what's hard for fee-only planners," says NAPFA member Cheryl Holland. "Sometimes we get stuck in a rut and think that some product is a horrible, evil thing, and then when it evolves we forget to go back and look at it. I'm not saying variable annuities are there yet, but there may be a time when they are."
Perhaps the future is now. Charleston, South Carolina, fee-only advisor Kyra Morris, like others of her stripe, had never touched VAs (other than in a 1035 exchange, which allows a tax-free trade of one annuity contract for another) until two years ago. "An attorney who makes $700,000 a year came to me and was all gung-ho about doing an annuity," Morris recalls, noting that the then-53-year-old lawyer projects to be in the top income tax bracket until retirement, making annuities' tax-deferred nature attractive. "He had his kids late in life - he has a 2-year old and a 5-year old - and he wanted to use the annuity to pay for his kids' college. He'll be retired then, and hopefully in a lower tax bracket." After the head of Morris Financial Concepts ran some numbers, she tiptoed the attorney into a VA. "We tried it," Morris says. "It was like, 'This kinda makes sense. Let's put $25,000 in the Vanguard annuity,' because compared to the other annuities that he was evaluating, the Vanguard annuity's internal expense ratios were so low." As it turns out, Morris has been so pleased with the annuity's performance that her client is set to dump another $50,000 into it.
Besides tax deferral, the other trait that distinguishes an annuity from all other beasts is its guarantee to pay an income for life. "That's one of the appeals of an annuity contract," says an executive at one provider. "You can't outlive it." That basic quality can be embellished in all sorts of ways - with a period certain (guaranteeing a minimum number of payments to beneficiaries, if death comes early), with a guarantee to provide lifetime income to both client and spouse, and so on. One VA feature that some advisors strategize around is the guaranteed death benefit, which makes payment to beneficiaries if the owner of the VA dies before receiving anything from it. In newer contracts, the death benefit is the greater of the value of the account, or the amount originally invested plus guaranteed annual growth of 5% or so.
"One scenario where we look at a variable annuity is with someone who is ill," says Dan Torbeck, chief investment officer at The Fitzgerald Lame Torbeck Group, a Cincinnati planning firm. A VA's death benefit, which is guaranteed to grow no matter how the account is invested, provides a floor on what will pass to beneficiaries, eliminating downside risk. "We had a client with terminal cancer who had a $5 million net worth, of which $3 million was in an IRA," says one of Torbeck's partners, John Lame, who converted the traditional IRA into a Roth, paid the income tax due on the conversion (reducing the client's taxable estate), and then bought a VA inside the Roth. "The break-even point of a Roth conversion moves back many, many years if the investments do poorly in the first few years after converting, so you want to be aggressive about the investments and try to grow those dollars as fast as you can," Lame says. He recommended the VA's small-cap sub-accounts to the ailing client (this was seven months ago) and yes, the value of the account did plummet during the spring. Even worse, the client died. "But the death benefit guarantee saved in the neighborhood of $350,000," Lame said shortly before Memorial Day. "And in this particular contract," he adds, "the guarantee actually continues to run all the way to the point that the estate is settled and we present a death certificate." Meanwhile, the heirs can still participate on the upside; if the VA's sub-accounts rally past the guaranteed death benefit amount prior to estate settlement, they'll receive the greater figure.
Better news is that older clients don't have to suffer falling stock prices for a death benefit guarantee to be advantageous. Again, with the guarantee providing a protective floor, you can go for broke inside the annuity, and if the investments pan out, 1035-exchanging into another contract allows you to establish a new, higher death benefit. Eighteen months ago, Lame had a 73-year-old client who put annuity money in tech stocks. "They ran, the value of his account appreciated by 40%, and then we pulled him out of that contract and went into a new one (via a 1035 exchange). The old contract had the old floor; we wanted a new floor with the 40% appreciation in it," says Lame, noting that this strategy only works with variable annuities that have neither front-end loads nor surrender charges. "We structure it so that it doesn't cost the client anything to go into the new contract or to get out of the old one." How is The Fitzgerald Lame Torbeck Group compensated? "There's a small percentage of our business (including the VA portion) that is commission-based," Lame says. "On the 1035 exchange, because the product pays a percentage of assets under management as a trail, there's no cost differential to the client. I know the no-load variable annuities are out there - I can't do 'em. I work at J.C. Bradford & Co. They don't carry them."
Guaranteed death benefits, of course, are nothing new. What's current in the marketplace is the bonus rate annuity. Also called credit rate annuities, these give the purchaser a signing bonus of sorts, letting the investor start the account with more than is actually deposited, say 3 to 5% on top of the premium. Sounds good, a bonus does, but it may not be. "The companies need to get the bonus money from somewhere, so they either reduce the representative's commission or increase the mortality and expense charge to the client for a number of years," says Gene Muenchau, national vice president of mutual funds and variable annuities at Fortis Financial Group, St. Paul, Minnesota. "I have heard that 40% of the companies are reducing commissions and 60% are doing the other." Providers issuing bonus rate annuities resulted in big increases in sales last year, according to Muenchau.
Another new twist in VAs is dollar-cost averaging bonus programs. Currently in vogue what with the stock market's volatility, these let the investor dollar-cost average into the VA sub-accounts. The client's premium is initially deposited into the carrier's fixed account, where it earns a high rate of interest - 12% at Fortis, for example; that's the bonus - while awaiting deployment into equities. "We move the money into the variable sub-accounts over a 6-month period," says Muenchau, explaining how Fortis's dollar-cost averaging program works.
While some annuity is- suers are adding new wrinkles, others are removing traditional features in the name of cost consciousness, and in hopes of drawing the fee-only crowd to annuities. "Just to take one example, the death benefit is a core feature of the broker-sold product," says Shane Chalke, CEO of AnnuityNet.com, which sells annuity contracts over the Internet. But annuity death benefits get hit by both income and estate tax, a major drawback for many individuals. "So we take out the death benefit to make the product a better value, because your money is better spent buying term insurance, the proceeds of which are exempt from income tax," says Chalke. AnnuityNet is developing a series of low-cost annuities it thinks will appeal to cost-conscious investors and fee-only advisors. "We're working with carriers to build products that are retirement savings vehicles and which aren't loaded up with a bunch of complex insurance features that have little value to many clients. We're really trying to mimic the no-load mutual fund world in the variable annuity arena," says Chalke, a former actuarial consultant bent on bringing VA costs down. "I know the annuity market inside and out from a manufacturer perspective," he says. "That's how we know what carriers are capable of doing."
The Web-based company is building a companion site for planners, AnnuityNetAdvisor.com (expected to launch June 30), that will let practitioners manage client accounts online. Prior to the launch date, a handful of planners had obtained power of attorney over their clients' AnnuityNet.com accounts, giving these practitioners the functionality of the advisor site even before it came online. "Directly from the Web site, you can access account balances, reallocate money, request withdrawals, and get historical statements," reports Kevin Gates of Technical Financial Services LLC, a Richmond, Virginia, fee-only investment management firm that has several clients with accounts at An-nuityNet.com. "The Web site is very easy to use."
Of course, that's inconsequential to fee-charging planners who don't want annuities in the first place. And there are good reasons not to. Stewart Welch, the Alabama advisor who abhors annuities - Welch gives VAs two thumbs down in his 1998 Macmillan book J.K. Lasser's Estate Planning for Baby Boomers and Retirees - thinks annuity products generally offer a limited choice of investment options. "Initially that doesn't sound like much of a disadvantage, but it really is," Welch says. Even if an annuity has funds that fall along the entire efficient frontier, he posits, is the large-cap growth fund in the top quintile? "And if it is, what are the odds that the small-cap fund is also in the top quintile? The difference between a top-quintile fund and a middle-quintile fund is going to be a pretty significant spread," Welch says. "By not using an annuity format, you're free to go out and find the best managers that are out there."
A bigger problem with annuities is the way they're taxed. Besides being included in the taxable estate at death, there's no step-up in basis for a VA passed to heirs, giving non-spouse beneficiaries an immediate tax bill on the growth. (A surviving spouse beneficiary can step into the shoes of the deceased and essentially roll over the annuity, continuing to defer income tax on the growth). Laura Tarbox, a Newport Beach, California, advisor who charges fees and detests VAs, says, "You put $100,000 in a mutual fund and it grows to $200,000, the beneficiaries inherit the $200,000 as cost basis and owe no income taxes. But if somebody invests $100,000 in an annuity that grows and then they die, the beneficiaries get the $100,000 cost basis and would have income taxes due on the growth." To mitigate that, Colorado planner Mark J. Smith sometimes advises clients who don't need the income to nevertheless drain their annuities during lifetime in order to reinvest in other vehicles. Yes, the client will incur income tax on payments received under the contract, concedes Smith, of M. J. Smith and Associates, Aurora, Colorado. "But the children will be better off on an after-tax basis because repositioning the money will allow stepped-up basis," he says.
Perhaps annuities' greatest tax disadvantage is that payments from them (or at least the portion of payments that represents growth in excess of cost basis) are taxed as ordinary income. Effectively, appreciation in an annuity gets converted from capital gains to ordinary income. But that seeming dysfunction can be put to good use, says Smith, whose fee-based firm likes annuities for 40-ish clients who make maximum 401(k) and IRA contributions and who have taken advantage of tax-managed funds. "When we feel we need, because of the diversification that we're seeking, to go into either small-cap funds that have high turnover ratios or certain foreign funds that aren't tax efficient" ( i.e., funds that would throw off significant ordinary income if not held in an annuity wrapper), "the variable annuity can make a tremendous amount of sense."
Indeed, if there's one thing that all planners, whether compensated by commissions, fees, or both, agree on, it's that a VA should only be used when it fits the client's situation. "Let me put that in perspective," offers Debby Vinyard, a planner who earns commissions in Marion, Illinois. "I could make twice as much money selling limited partnerships, but most of those never make any money for the client, so I certainly wouldn't recommend them. All things have to be there in order to recommend a variable annuity for a client, not just the commission."
It's no secret that VAs have been selling like there's no tomorrow, but what does the future hold? Suppose costs really do come down. If planners who charge fees can find strategic uses for annuities, like Kyra Morris has, wouldn't that skyrocket the already booming annuity business? "We actually believe that the market for variable annuities is really far larger than people speculate. Annuities have only penetrated the commissioned-broker space," says AnnuityNet's Chalke. "That's a powerful space, and an important one, but we think the variable annuity market could be double what it is today."