Variable annuities sold on commission remind me of old cars that constantly need fixing. They are expensive to maintain and hard to unload...

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Variable annuities sold on commission remind me of old cars that constantly need fixing. They are expensive to maintain and hard to unload.

Variable annuities combine mutual funds that offer tax-deferred compounding with insurance features, such as a death benefit to survivors and guaranteed retirement income.

Many investors and employees in small retirement plans have been hurt by these investments, which often are larded with exorbitant expenses and beset by taxation.

Numerous investigations have turned up violations in how they are marketed and the risks disclosed.

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Regulators recently have stepped up scrutiny of variable-annuity sellers.

In April, Waddell & Reed of Overland Park, Kan., agreed to settle a complaint by the National Association of Securities Dealers (NASD) and a group of states by paying a $5 million penalty and $11 million in restitution to 5,000 customers who allegedly were switched in and out of variable annuities to generate commissions. Some 400 Washington investors were included in the settlement.

The firm, in a statement, neither admitted nor denied wrongdoing.

New York Attorney General Eliot Spitzer has gotten into the act. In June, he subpoenaed Hartford Financial Services Group of Connecticut for information on annuity sales to customers 65 and older.

Neither Spitzer nor Hartford, which disclosed the subpoena in a Securities and Exchange Commission filing, would elaborate.

A Hartford spokesman said the company was cooperating with the request. The SEC is eyeing a new rule on annuities sales. The NASD, the securities-industry regulator formerly known as the National Association of Securities Dealers, is also considering tighter regulation of annuities indexed to the stock market.

Annuity salespeople can do very well, reaping commissions as high as 9 percent. The industry has about $1.1 trillion in annual sales.

By comparison, if you were to sell a house, the real-estate commission runs from 5 to 6 percent.

The top commission on a “load” mutual fund is 4.5 percent.

Tom Grzymala, a certified financial planner and principal of Forensic Analytics in Keswick, Va., wants to see tighter federal regulation of annuities and says investors rarely have enough information when salespeople make their pitch.

“Annuities fall under the insurance umbrella more than securities regulation,” Grzymala says. “The bottom line is the consumer is the one who suffers.”

Little to offer

Unless tax laws are changed, variable annuities will continue to be an undesirable investment from a retirement tax-planning perspective. Both contributions and withdrawals from annuities are fully taxable at marginal personal rates up to 35 percent.

The main feature of annuities is tax-deferred compounding and insured payouts.

They have applications in estate planning, though they are best employed by financial planners who don’t receive commissions and get a fee instead.

Total expenses on annuities often exceed 2 percent a year, in addition to commissions, so these products can seriously impair total return. Most commissioned annuities also lock you into a contract for up to 12 years.

If you try to get out before the surrender period, you pay a steep fee.

In contrast, you can own a stock-index mutual fund or exchange-traded fund for 0.20 percent a year or less, and you would qualify for the 15 percent capital-gains tax (in most tax brackets) after holding them for a year.

Regulation proposed

The NASD has proposed a new rule that would require brokers to follow suitability guidelines when selling annuities.

The rule is pending before the SEC, and it’s not certain whether the proposal will curtail marketing abuses.

Mike DeGeorge, general counsel for the National Association of Variable Annuities, the industry’s trade association, said his group prefers model regulations offered by the National Association of Insurance Commissioners, a state regulators’ group.

“In the last year, five states adopted the state model regulations,” DeGeorge said. “The industry supports the model, because we’d prefer to see uniformity among the states rather than a patchwork of regulations.”

If you don’t incur a withdrawal fee, you can transfer your annuity into a similar, low-cost annuity through a 1035 Exchange, which permits a tax-free transaction.

All of the major mutual-fund firms offer these without charging a commission. T. Rowe Price Group, the Baltimore-based mutual-fund company, for example, sells a no-load variable annuity free of both commissions and withdrawal fees.

There are varying management fees on the mutual funds within the annuity, plus a 0.55 percent annual charge for insurance expenses.

The industry average for insurance fees is about 1.24 percent a year with the average surrender fee of 6 percent.

If you’re allowed to make a cost-free transfer, the savings are significant.

By lowering your total annuity expenses from the industry average of 2.35 percent to 0.58 percent, you could save more than $1,700 for every $100,000 invested, according to Valley Forge, Pa.-based Vanguard Group, the second-largest mutual-fund company and a low-cost annuity seller.

Not all rotten

Not all annuities are tainted. Fixed or “immediate” annuities, for example, guarantee an income stream for life.

For those with traditional pension plans, fixed annuities can be used to supplement income, provided all of your other retirement programs are fully funded.

These types of annuities are also useful for converting lump sums from 401(k)-type plans to monthly payments.

Several legislators have proposed adding annuitization features to 401(k) accounts and providing some tax breaks, a solid idea for retirees who only have these savings plans. Perhaps such a law, if passed, will contain enough safeguards to prevent abuses.