A recent Bloomberg Businessweek article highlighting what it calls the “drawbacks” of annuities is the latest in a long line of articles panning the financial products. But do annuities—especially variable annuities—deserve their bad reputation, or are annuities just an easy target of the mainstream media? And where annuities are the right choice for your clients, how can you counter the negative press to help them make the right investing decision?

Hinting that the stability offered by annuities is just a “marketing message of the insurance companies,” the Businessweek article glosses over the complexity of investing decisions.

Every investment product has its place, each serving a distinct need. No one is claiming that variable annuities are right for every investor.

Annuities generally form only one component of an investor’s strategy. Fixed annuities, for instance, are criticized by the article as exposing the consumer to inflation risk. But fixed annuities are generally used to protect investors from market risk—not inflation risk. And the opposite criticism could be levied against mutual funds: although mutual funds generally insulate investors from inflation risk, they don’t insulate the investor from market risk.

Every investment product has a distinct role to play.

Aren’t Mutual Funds Good Enough?

Although the March 15 article criticizes both fixed and variable annuities, its harshest criticism is directed at variable annuities, which it defines as “a mutual fund inside an insurance contract.” Because “fees and expenses are often much lower for mutual funds,” the conclusion seems to be that mutual funds are preferable to variable annuity contracts.

One of the primary advantages of annuity contracts, their ability to defer tax, is glossed over by the article as being “exaggerated by annuity sales pitches.” But whether or not individual advisors may exaggerate the tax benefits of annuities, the fact is that the investors aren’t taxed on the inside buildup of a variable annuity, whereas mutual fund dividends are taxed on an annual basis.

And there’s another important tax distinction between variable annuities and mutual fund investments—the cost of reallocating investments. To move assets from one mutual fund to another, the investor will have to sell off his interest in one mutual fund, paying income tax on any gain, before moving the investment to another fund. In contrast, movement of assets between subaccounts of a variable annuity doesn’t generate taxable income.

The mutual fund sale and purchase can also include significant loads and other fees (e.g., trading fees). Variable annuities, on the other hand, often permit investors a number (e.g., 12) of fee-free reallocations between subaccounts. Others offer unlimited movement between subaccounts.

As a result of the free transferability of assets between subaccounts, the owner of a variable annuity can respond to market conditions without the disincentive of income tax liability or fees.

What’s the Bottom Line?

Variable annuities offer a level of flexibility not available with mutual funds by offering optional riders that can be picked up to meet an investor’s particular needs—whether fixed income or principal protection. Variable annuities can thus offer certainty, where mutual funds are subject to the ups and downs of the market.

Most of the negative press on annuities seems to be prefaced on a false dichotomy—that annuities are either right or wrong for every investor. As with other investments, the suitability of variable annuities is going to depend on the particular characteristics of the investor. And that’s where the advisor comes in.

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See also The Law Professor's blog at AdvisorFYI.