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Since I got such a wonderful reply to my previous question which I tagged onto another thread, can I go ahead and ask a broader question about variable annuities? My reading so far hasn't mentioned them at all, and looking through my friend's brochure made it seem like an IRA with a head cold. So my question, which can be answered privately if nobody wants to bore the rest of the board:
What exactly is a variable annuity when compared with the other classic non/401k type retirement vehicles such as Roth and Traditional IRAs? Why on earth would anyone want to choose a VA over any other kind of investment? Are there actual advantages to VAs that no other similar retirement portfolio can touch? Thanks!

The Exchequer
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Exchequer asks:

<<Since I got such a wonderful reply to my previous question which I tagged onto another thread, can I go ahead and ask a broader question about variable annuities? My reading so far hasn't mentioned them at all, and looking through my friend's brochure made it seem like an IRA with a head cold. So my question, which can be answered privately if nobody wants to bore the rest of the board:
What exactly is a variable annuity when compared with the other classic non/401k type retirement vehicles such as Roth and Traditional IRAs? Why on earth would anyone want to choose a VA over any other kind of investment? Are there actual advantages to VAs that no other similar retirement portfolio can touch?>>


Regardless of who sells it to you, a tax-deferred annuity, or TDA, is a contract between you and an insurance company. In exchange for your hard-earned cash the insurance company agrees to pay you an income for a specified period or for your life. Those payments may start at some date in the future or they may start on the day you buy the contract. If the payments are delayed until the future, you have what's called a deferred annuity. If the payments start immediately, you have an immediate annuity. You pay for an immediate annuity with a lump sum of cash on the day you buy it. You pay for a deferred annuity either with a single lump sum payment or with a series of payments made over a number of years. Your investment in the annuity will earn a return, and those earnings will be untaxed until you receive annuity payments. On distribution, the earnings are taxed at ordinary income tax rates in effect in the year of payment. Also, unless you purchase it within an IRA, you will receive no tax deduction for any investment you make in a TDA, only a tax deferral on any earnings that result from that investment.

TDAs come in three flavors: fixed, variable or equity-index. As the name implies, a fixed annuity provides a specified rate of return on the the investment and a fixed, stable income in its payout phase. In this type of annuity the insurance company quarantees the rate of return and the amount of income to be paid. For that reason, a fixed annuity provides a steady retirement income, but offers little protection against inflation. When the contract is annuitized (i.e., when annuity payments actually begin), the resulting income is generally fixed for the life of the contract. Options are available at a price to have those payments increase by 3% to 5% each year should you so desire. When used, the payments under that feature will be lower than the fixed payments intitally, but over the years they will steadily increase at the contracted rate. For those expecting to live many years, the added cost of this feature may be worth the price.

In a variable annuity, the purchaser decides how to invest the money within a range of mutual fund look-alike investment options offered by the insurance company. These investments are called subaccounts. They often carry the same name and are operated by the same investment managers as publicly offered mutual funds. Nevertheless, they are not the same funds because by law they cannot be. While these subaccounts may invest in the same instruments as those in the mutual fund, they almost certainly will have a different expense structure and possibly a far different return than that of the public fund. A variable annuity will typically offer a selection of stock, bond, and money market subaccount investments. Thus, unlike the fixed annuity, the returns of the variable annuity are not stable, and will vary with both market values and the annuity buyer's investment choices. While this variation does have a downside risk, it nevertheless affords the annuity buyer the ability to participate in the potentially greater returns of the stock market. In the annuity payout phase, as the stock market rises, so does income derived from an investment in a stock subaccount. Conversely, as the market declines, so will income. Still, over the long-term, a variable annuity invested in a stock subaccount should provide a much better opportunity for inflation-protected income than does a fixed annuity.

A recent innovation in the insurance industry, an equity-index annuity is a contract that offers both the opportunity for stock returns as found in a variable annuity coupled with the guarantee of a stable minimum return as found in the fixed annuity. In this contract, the purchaser invests in a subaccount that seeks to emulate the performance of a well-known equities index such as the S&P 500. Thus, the purchaser is able to participate somewhat in stock market gains during a rising market. If stocks fall, then the contract guarantees a minimum return, typically 3%. Because of that guarantee, the equity-index annuity has less downward volatility than the variable annuity. It will also limit full participation in the returns of a rising market to compensate for that guarantee. One way is to tie equity-index returns to those deriving from market price changes only, and excluding any due to the payment of dividends. As an example, in 1998 the total return (i.e., capital gains and dividends) for the S&P 500 Index as reported by Ibbotson Associates was 28.6%, while that for just capital gains (i.e., market price) was 26.7%. An equity-indexed annuity tied to the S&P 500 Index would typically use the smaller return in that product. Most equity-index annuities use something called a "participation rate" to also limit returns. For instance, the insurance company may declare a participation rate of 90%, which means the annuity would be credited with only 90% of the gain experienced by the equity index for that year. If the index gained 10%, then the gain in the annuity would be 9% for the year.

It's no secret that within the confines of Fooldom we generally eschew annuities as an investment. They by and large are expensive, offer mediocre insurance coverage, and restrict the owner's investment choices to so-so, ho-hum mutual fund look-alike subaccounts. While they do provide for tax-deferred investment growth, that growth is taxed at ordinary income tax rates on withdrawal. Further, the vast majority of annuities lack liquidity. Cash in early, and you will often face steep surrender fees of 5% to 10% that won't disappear until you have held the annuity for at least 3 and up to 12 years in some cases. We believe most strongly that Foolish investors can do far better for themselves elsewhere. Indeed, unless you have a (f)oolishly altruistic desire to line a broker's pockets with big commissions, we believe annuity products are appropriate only for those who:

a. Have contributed the maximum to their 401k plans and IRAs and desire further tax deferral on investment gains.
b. Prefer investing in mutual funds as opposed to individual securities.
c. Will keep the annuity for at least 15 to 20 years.
d. Are in a 28% or higher income tax bracket today, but expect to be in a lower income tax bracket in retirement.
e. Don't need the annuity proceeds prior to age 59 1/2.
g. Are unconcerned that heirs must pay ordinary income taxes on any appreciation.
h. Desire a "guaranteed" income for life in retirement.

It's not hard to determine why we believe all those conditions must be met before an annuity is a desirable purchase. Tax deferral helps earnings grow, but cheaper investment choices exist in company retirement plans and IRAs than those found in the typical variable annuity. Why let expenses eat into returns needlessly? Fools use those vehicles first. Additionally, with tax efficient, low cost, no load taxable index mutual funds as an alternative, after consideration of income tax impacts a better performing subaccount within an annuity would still require at least 15 to 20 years to produce a better net accumulation. As Fools, we prefer the greater potential returns found in self-selected stocks, so that period would be much longer. Using an identical investment, an annuity works better than a taxable account only if income tax rates fall in retirement. Fools expect their income tax rates to remain the same. Also, unless we intend to take lifetime payments, we can't retire or tap into the annuity prior to age 59 1/2 unless we're willing to pay a 10% early withdrawal penalty to Uncle Sammy. Annuities are less kind to heirs, too. With a taxable account, our heirs receive our investments at market value. They can sell immediately without an income tax impact. With the annuity, they must pay ordinary income taxes on any gain in that account.

For retirees, an annuity offers the assurance of a stream of income for life or for a specific period of time. For those who fear the potential loss of all their money because of poor investment choices, that "guarantee" is important. As Fools, we recognize that this "fear factor" is real and does enter into many people's investment decisions. Accordingly, we fault no one who chooses lower risk approaches, and that's especially true of those who are retired. But as Fools, we do urge those interested in annuities to recognize their costs, their investment limitations, and their limited potential for passing on wealth to heirs. If after your evaluation of all those factors an annuity still appears appropriate, then as Fools we also urge the purchase of a low-cost annuity such as one of those offered by Vanguard, T. Rowe Price, Fidelity, AnnuityNet.com or (in some states) TIAA-CREF. Why pay commissions and high expenses when you don't have to? That enriches the fat cats at your expense, and no Fool wants to do that. Keep the money in your pocket instead.

So there you have the Foolish skinny on annuities. No, we don't like them much. Still, they serve a purpose and are appropriate under some circumstances. As an insurance product, their primary purpose is to protect income. As an investment, their primary purpose is to accumulate the assets necessary to produce that income. Annuities can meet both those needs satisfactorily. But then a whole host of other, more rewarding, products can, too. Consequently, prior to purchase you must examine all your options closely to ensure you will get the most for your hard-earned dollar. Determine whose income you want protected, yours or your family's after you're gone. Establish when and for how long that protection is needed. Clarify your estate desires. Then examine your options in that context. As you do so, keep in mind that the more features you add to an annuity, the more costly it will be and the less income it will produce. Remember, too, annuities are a long-term commitment, so view them as something that you will hold for decades, not a year or two. If after a full evaluation of all your options you decide an annuity meets your needs best, then you have made a Foolish choice.

Regards..Pixy
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I appreciated this most thorough explanation of annuities, but still have some questions.

As a school employee, a 401k isn't avaialable to me, but a 403(b) is, which to my understanding is similar to a 401k. On the other hand, the term "tax-sheltered (or deferred) annuity" seems to be used somewhat interchanagbly when talking about a 403(b). Maximizing a 401k is emphasized, but a variable annuity isn't. To my understanding I can't invest directly in stocks through my 403(b) (though I do in my IRA), so I have no choice but to invest in mutual funds. And since I can only invest $2000/yr in an IRA, doesn't it make sense to invest in a 403(b)/TSA so that I can invest $10,000/yr tax-deferred, as opposed to investing that money directly in stocks that I will have to pay taxes on?

I know this reply is somewhat stream-of-consciousness. Any help/answers greatly appreciated.
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As a school employee, a 401k isn't avaialable to me, but a 403(b) is, which to my understanding is similar to a 401k. On the other hand, the term "tax-sheltered (or deferred) annuity" seems to be used somewhat interchanagbly when talking about a 403(b). Maximizing a 401k is emphasized, but a variable annuity isn't. To my understanding I can't invest directly in stocks through my 403(b) (though I do in my IRA), so I have no choice but to invest in mutual funds. And since I can only invest $2000/yr in an IRA, doesn't it make sense to invest in a 403(b)/TSA so that I can invest $10,000/yr tax-deferred, as opposed to investing that money directly in stocks that I will have to pay taxes on?

I believe that most 403(b) plans are written through insurance companies as annuities. Not all annuities are bad, as is sometimes implied. As long as the fees are really low, they aren't so bad. In 403(b) plans you are, by law, limited to mutual funds or annuities. 403(b)7 plans invest only in mutual funds. Your school may or may not offer 403(b)7 plans, but it's worth checking into if you do not want an annuity. I found out by accident that our school has something like 20 different companies to choose from, and although the vast majority were annuities, I chose Fidelity with a 403(b)7 in mutal funds w/o annuities. Someone might correct me if I'm wrong, but I was told that there is no loan provision with a 403(b)7. Might make a difference if you want to use some of that money to buy a house later on.

My take on the Foolish investment strategy would be to first invest your $2,000/year into the IRA where you can buy stocks according to your favorite method(s) (Foolish Four, Rule Maker, Rule Breaker, throw darts at financial page, etc). This also make sense since you probably don't get any matching funds. After funding the IRA, then put money into the 403(b), probably an S&P 500 index fund, since over the long term (and usually the short term!) they beat 80-90% of managed mutual funds.

How much to put into the 403(b)? Depends on how much you want the tax-deferal, and if it is worth waiting to pay the taxes after you retire, and what kind of returns can you get in a taxable account with a discount broker. Buy and hold strategies result in a long-term capital gains taxes, which may be significantly lower than income taxes on traditional IRA and 403(b) withdrawls after retirement. Some of it depends on how much you want the tax deferal now, or if you want a lower tax bill later.

Hope this helps and wasn't too unorganized,

Taylor
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Taylor - You pretty much nailed it! TSA's do allow for loans, while 403b(7) accounts in mutual funds do not. One other feature TSA's offer is a variety of different investment companies (i.e. the one I use has accounts managed by Janus, T Rowe Price, Fidelity, Scudder, Calvert, Harris Oakmark, State Street Research, etc.), so one is not limited to one family of funds...

Regarding Roth/IRA's & 403b plans - they are quite complementary, IMHO...

Regards, PP
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Thanks to those who replied to my questions, and here's just one more (I promise!).

I'm concerned about the benefits at retirement. Is a 403(b)/TSA just like owning a mutual fund, in that I can simply call the company when I want money and tell them to send me a check for X amount of dollars. Or is it going to be like a traditional annuity, which, I think, involves my guessing what amount I want paid to me at what interval, meaning if I die young I'm screwed out of the remainder of the money invested, or if I live long enough I actually make more than my account was worth. Additionally, would my heirs inherit what's left in my account, like any other mutual fund account? The term "annuity" and dealing with an insurance company just makes me wary.

Thanks, again.
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hi collegefool -

While I won't presume to speak for all TSA providers, the one I work with allows a variety of payout options, one of which is the guaranteed stream of income plan (immediate annuity), which I don't usually recommend. Other withdrawal options include: withdraw as you need it, and a scheduled payout - quarterly/monthly, etc. which can be modified as you wish.

Because you name beneficiaries, in the event you pass away before depleting all the funds, the balance will pass to them! If your spouse is the beneficiary he/she has the option to treat the retirement account as if it were his/her own & follow the same rules. Any other beneficiary has a different set of IRS rules to follow (which require withdrawal schedules sooner).

By-the-way, the "onerous" immediate annuity does NOT result in forfeiture of the balance of funds when the annuitant dies, unless the choice of payout so states - a VERY poor selection!!! Beneficiaries can also be named to receive the lump sum balance or the balance of scheduled payments...

Hope this helps. Good luck, PP
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FYI-age 29 recently employed by school district at $75K

After searching previously posted information on this board, I found your post extrememly helpful.

I'm wrestling with a similar dilema. I can invest in a 403(b)7 offered by a list of institutions. It's non employer matched. I don't currently invest in IRA, but will probably do so in 2000. I enjoy playing the market (Foolishly) and continue to read, research and learn how to do it better. I understand that investing in the market, long term, will historically speaking, blow away most Mutual funds and annuities.

I am not sure whether I should start the IRA, put the max into the 403b, and/or invest in the market as I've been doing, on my own.

Any insight would be very helpful.

-JB
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Greetings, JB, and welcome. You wrote:

<<I'm wrestling with a similar dilema. I can invest in a 403(b)7 offered by a list of institutions. It's non employer matched. I don't currently invest in IRA, but will probably do so in 2000. I enjoy playing the market (Foolishly) and continue to read, research and learn how to do it better. I understand that investing in the market, long term, will historically speaking, blow away most Mutual funds and annuities.

I am not sure whether I should start the IRA, put the max into the 403b, and/or invest in the market as I've been doing, on my own.

Any insight would be very helpful.>>


Depending on how you intend to invest those proceeds, it's possible to beat the tax deferred account in a fully taxable investment. To determine that, you must run a tax-equivalent analysis of your options. I suggest one way to do that in Step 4 of my 13 Steps to Foolish Retirement Planning available at http://www.fool.com/Retirement/Retirement.htm. Run a similar analysis for yourself, and you can tell if you're better off not using the 403b. Just remember that if you don't, you must remain just as dedicated in the alternative as you would have been within the 403b (i.e., contributions that occur every payday and that increase as your pay does). Otherwise, that plan won't work.

Regards..Pixy
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