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.