Variable annuities and current tax law.

With the reduction in capital gains rates in the Taxpayer Relief Act of 1997, will the tax deferral investors received within a variable annuity continue to compare favorably to investments made outside a variable annuity (e.g., in a regular brokerage account)?

A variable annuity (offered for sale exclusively by life insurance companies effectively) is a group of investments consisting primarily of mutual funds and, in most situations, includes a guaranteed fixed-return investment choice. What distinguishes a variable annuity is that the investments are enclosed within an insurance "wrapper" that allows the investor to earn dividend and capital gain distributions, and realize gains from the sale of shares of the enclosed mutual funds on a tax-deferred basis. The insurance wrapper is made available to an investor at a price--additional mortality and administrative expenses over and above those found in all mutual funds, including those within the wrapper. A variable annuity is most widely sold as a form of supplemental retirement plan, as tax penalties exist (with only certain exceptions) that affect withdrawals made before the age of 59 1/2. All appreciation in total value in excess of an investor's original contribution is taxed when withdrawn, at ordinary income rates. Systematic withdrawals made over an investor's life expectancy are available, with taxable appreciation and return of original contribution recognized on a pro rata basis under Sec. 72. "Nonannuity" payouts are "penalized" by being treated as gain first (subject to ordinary income tax rates until the value remaining within the annuity is reduced to contributed basis), and then as capital return.

Many insurance companies sell variable annuities through agents who earn commissions on sales, while others are direct-marketed. How a product is marketed usually has a dramatic effect on its costs, with commission-sales products having average additional wrapper-related expenses of nearly 1.5%. The more competitive products, found through the insurance arms of certain discount broker/dealer and mutual fund companies, are far more cost-effective, with wrapper-related expenses generally averaging between 50 to 80 basis points.

The reduction in capital gains rates has had no effect on the taxation of variable annuities; all gains, whether ordinary or capital when earned, are ultimately taxed on withdrawal at ordinary income tax rates. However, a reduced capital gains rate is a consideration when comparing taxable alternative investments to a variable annuity.

One alternative would be an investment in a group or family of mutual funds in a regular brokerage account. Thinking in terms of a family of mutual funds is probably the best comparison, because they usually provide for a substantial number of transactions within the family at no additional administrative charge.

Under modern portfolio theory, an appropriate asset allocation is fundamental to effective and profitable investment management; using a mutual fund family to accomplish this makes sense. Distributions would be currently taxed as characteristics of the income dictate; similarly, gain or loss incurred during repositioning of investments would be recognized. Both "regular brokerage account" investments and those within a variable annuity provide the investor with investment diversification and professional investment management, in exchange for a management fee. That fee is effectively the expense ratio of a specific fund.

Assuming these fees are the same, it is easy to conclude that the variable annuity, because it is tax-deferred, would grow in value more quickly than the taxable mutual funds held in the regular brokerage account. However, experience has shown that, since the reduction in capital gains rates, an investor would have to hold a variable annuity longer to recognize the same value.

What does this mean to today's investor? There is clearly a need to consider a variable annuity as an appropriate retirement planning alternative. In particular, consideration is appropriate when the planning horizon offers at least 15 to 20 years to use the deferral to advantage. Still, an economic comparison against a taxable alternative should be reviewed. In other long-range investment planning situations, when tax deferral is a key element, the variable annuity is a viable option. However, estate planning considerations may become an additional concern in the decision-making process.

A variable annuity will continue to have additional applications when new annuitization features (or the surrender of capital accumulation in exchange for a cashflow stream) are appropriate for specific clients. While this choice used to be an all-or-nothing decision, new products provide more attractive planning alternatives. For instance, certain products allow partial annuitization, while allowing for a continuing investment pool focused on generating growth, so that the ongoing annuity cashflow may provide a hedge against inflation. Also, there is a large body of literature supporting the use of variable annuities as the investment vehicle of choice in net income make-up charitable remainder trusts, to ensure that there is no accidental income.

FROM WAYNE WILLIAMS, CPA, CFP, CHICAGO, IL