Some planners recommend them; others think that's malpractice.

The field of finance abounds with controversies, but few engender such heated debate as the question of whether it's appropriate to use annuities in IRAs and other qualified accounts. Not too surprisingly, those who find favor with this practice are often the ones selling annuities, although planners of all compensation stripes will take the other side of the debate.

Before exploring the different sides of this complex issue, let's give it some structure. Any discussion of annuities has at least four dimensions to it. There are fixed annuities and variable annuities; they have an accumulation and a distribution phase; there are tax effects to consider; and there is the issue of timing their purchase.

How about cost? Yes, cost may be an issue, but a more controllable one. While certain annuities can be very costly, a fee-only or otherwise client-centered planner can find low-cost annuities from companies like Vanguard or Aegon, among others, if he tries hard enough.

Even annuities that seemingly pose a high cost may not really do so when compared with alternative investments, says Richard Hall, an Albuquerque, N.M., fee-and-commission planner. "If you use a load fund, your client will pay 5.75% up front and a .25% or higher 12(b)1 annual cost ... or, if you use C shares, a 1% to 1.5% 12(b)1 trail. If you're an assets-under-management guy, you'll charge 1% to 1.5% per year. The annuity I use has a 1.15% annual M&E and admin fee, and a seven-year declining surrender charge that is only relevant if the client takes out more than 10% per year. So, on an annual cost basis, it appears the annuity is equivalent to either load mutual funds or no-loads in an AUM [assets under management] program."

Putting aside the issue of cost, many planners still make up their minds about annuities in IRAs based upon maybe two of our four dimensions, but seldom the complete picture. If we instead consider all four dimensions, it's possible to make a more educated decision for our clients.

Let's start with fixed annuities. By using the "fixed vs. variable" dimension as the pivot-point of our analysis, we can more easily discuss the realities of accumulation vs. distribution, tax effect and timing on the decision to invest in annuities for our client.

Fixed Annuities

Are fixed annuities appropriately bought for a retirement-age client in his IRA or qualified plan? At certain times, they just may be, says Kathleen Cotton. Cotton is the owner of Cotton Financial Advisors Inc. in Lynnwood, Wash., and a fee-only planner who, she says, "sold tons of fixed annuities back in my broker days."

"The fixed annuities that I placed in IRAs were put there for their value as an investment vehicle, not for their tax deferral," she says. "It was not uncommon to find annuities paying more than bank CDs or bonds. Renewal rates on such annuities were good in that they paid the same rate on renewals as they did for new annuity contracts. This meant they kept their slightly superior yield position over time. Because a fixed annuity has no internal expense, my clients realized the stated rate."

Does the annuitization of an existing fixed annuity, or the purchase of an immediate fixed annuity for retirement income, make sense? F. Dennis De Stefano, owner of De Stefano Wealth Management in Maui, Hawaii, thinks not. "If a fixed annuity is used to provide a lifetime income, then your client has acquired an investment guaranteed to go down in value each and every year as inflation erodes the purchasing power of the income stream," he says.

How about the tax effect? So many planners, like Carol Wilson, for example, feel that a tax-deferred vehicle has no place in an IRA or qualified plan that is, in itself, tax advantaged. Says Wilson, owner of Salt Lake City, Utah's Wilson Financial Advisors Inc., "I am an insurance consultant for the state of Utah, and whenever I see an annuity inside a tax deferred vehicle, I discuss with the client the high cost of having this annuity there in the accumulation phase." Echoes Warren McIntyre with VisionQuest Financial Planning in Troy, Mich., "Annuities are sold because the 'advisor' makes the most money on this product." In which case, adds McIntyre, is the seller really going to avoid the huge IRA market just because it's the right thing to do? "Of course not," he says.

It seems the tax argument can only be overcome in the case of a fixed annuity if its after-tax performance, as Cotton occasionally found, exceeds that of its non-annuity competition. Even if that's the case, though, is this the time to buy a fixed annuity?

No, says Bernie Kiely, CPA, CFP and owner of Kiely Capital Management in Morristown, N.J. "For the past year, I've been warning clients not to buy an immediate annuity. If they do, they will be locking in historically low interest rates for the rest of their life," he says.

Clearly, fixed annuities used in qualified vehicles don't stand up well to scrutiny at this time; or, many planners would claim, at any time. In fact, many of the arguments against fixed annuities apply whether or not they are used in IRAs or qualified plans. Do variable annuities fare any better?

Variable Annuities

Variable annuities, with their equity participation opportunities, take on an entirely different persona. Should they be used by planners in qualified vehicles in the accumulation phase? This is where one gets the most arguments about their cost inefficiency and the fact that non-annuity counterparts can easily be found in the vast world of mutual funds. Even if Hall's argument about the cost-neutrality of annuities is valid, the sheer number of mutual funds available for use in client IRAs would seem to represent a better opportunity than a fixed number of variable annuity sub-accounts.

This perception changes, however, when we examine variables from the standpoint of distribution. Annuities, in general, are most useful in that they provide guaranteed lifetime income. Indeed, the renewed interest many planners are showing in annuities today is in using them as a part of their client's retirement portfolios to better the odds that clients won't outlive their savings.

Says Dan Roe, a principal with Columbus, Ohio's Budros & Ruhlin Inc., "I can fully appreciate the analytical support I've seen for the use of annuities during the distribution phase of a portfolio." Since IRAs and other qualified vehicles are designed to provide retirement security, Roe concedes annuities may be appropriate in IRAs if the client receives the type of "rising guarantee" some annuities offer.

Hall says the guarantees Roe speaks of are precisely what give variable annuities an advantage over competing instruments. "The return-of-premium death benefit feature or, for a slightly higher premium, an annual step-up in death benefit amount, often have very real value these days," says Hall, referring to the stock markets of 2000-2003.

The implication of both Roe's and Hall's comments is that annuities must be a deliberate part of a client's retirement strategy, meaning there must be the intention to annuitize at some point in the future and not just hold them indefinitely in the accumulation phase.

So let's assume competitively priced annuity products can be found and annuitized advantageously for retirement-minded clients. Do planners still have a problem with the tax aspect of putting a tax-favored variable annuity in a qualified plan? Says Scott Leonard, owner of Leonard Wealth Management in El Segundo, Calif., and licensed to sell annuities before going fee-only, "There is zero justification for putting a tax-deferred annuity inside an IRA. However, when it comes to annuitizing, the argument flips and a very strong case can be made that the product belongs inside an IRA, because the distributions from an annuity and an IRA are both taxed as income, and do not benefit from the decreased capital gain or dividend tax rates." This is a reference to the recently-passed Jobs and Growth Tax Relief Reconciliation Act of 2003, which cut dividend taxes while further lowering taxes on capital gains.

Hall takes this argument a step further, saying, "The problem I have is with annuities outside of qualified plans. Those clients who have the funds to do this are in high tax brackets, and annuities simply are not tax efficient, particularly compared to deferring capital gains [on taxable investments]. I have done an analysis using 7% to 12% growth assumptions for I-Shares vs. taxable annuities, and I believe the I-Share option gives twice the retirement income of annuities. Furthermore, the new capital gain and dividend tax rates will make annuities fall behind even taxable mutual funds [in after-tax return]." All of which recommends leaving variable annuities in qualified plans and certain taxable investment outside of such plans.

OK, but is this the right time to buy an immediate variable annuity? Annuitizing a variable product might be just the thing to do in today's market environment, says Scott Dauenhauer of Meridian Wealth Management in Laguna Hills, Calif. "I rarely annuitize [fixed annuities], especially in today's low interest-rate environment, but annuitizing on a variable isn't a bad idea with stocks so low."

We conclude, then, with the finding that now may be the time to consider the purchase of a variable annuity for your client's IRA, armed with the right guarantees and the intention that it provide lifetime income. Not convinced? Use our four-dimensional framework to decide whether your hesitation comes from a clear-headed analysis of the facts or a clinging to your biases of the past.

David J. Drucker, MBA, CFP ([email protected]), a fee-only financial advisor since 1981, is co-author of the book Virtual Office Tools for the High-Margin Practice (Bloomberg Press, 2002) and editor of the Virtual Office News newsletter.