Bird in Hand

Deferred annuities are generally best for those looking to use the money in retirement, says Reagan of Fleischer Jacobs. While an investor could set up a deferred annuity while young, Reagan warns that the investor should avoid pulling money out of it before he reaches age 59 1/2 because he'll be charged a 10% tax penalty for each withdrawal. Indeed, DeGeorge says a deferred annuity could be a great choice for a 51-year-old like himself who will probably continue working for another 15 years and live until age 82. If a 51-year-old retires at age 65, he'll have another 20 years in retirement, so a "deferred annuity may still make sense" for him because he can "build up money on a tax-deferred basis, and then convert the money to a lifetime income stream to supplement Social Security."

An immediate annuity makes the most sense for an older person looking for some type of lifetime income, DeGeorge says, adding that the majority of people purchasing immediate annuities choose fixed annuities "because they like knowing the amount they will receive each month is never going to vary." Harold Evensky, chairman of Evensky, Brown & Katz in Coral Gables, Florida, says his firm is "really interested" in using immediate fixed annuities for its retirees because the need for cash flow is replacing accumulation as the dominant planning goal.

Reagan says one of the criticisms of deferred annuities is that the investor "defers all of [his] income and then at death the beneficiary is stuck" with paying taxes on the gains in one lump sum. But recent private letter rulings issued by the Internal Revenue Service to some financial services companies allow a beneficiary to stretch out the annuity distributions over time. With the stretch, "the beneficiary can spread the tax payments out over their life expectancy," Reagan says.

To DeGeorge, the biggest challenge facing the annuity industry remains that of meeting the needs of retirees. "There is a tremendous population of people retiring, and there are countless studies that show those people are woefully unprepared for retirement," he says. Most people "haven't saved enough, and haven't planned" for retirement. "Even people who have saved money don't have a plan for how they're going to spend it and make it last throughout retirement." DeGeorge further argues that "many financial planners believe that annuities, on the payout side, do have an important role to play" in clients' portfolios.

But advisors and their clients wonder why anyone should purchase a deferred variable annuity in a qualified tax plan that offers its own tax deferral. One reason: "It's an easy sale" and commission for the broker, and "there are no breakpoints," says Evensky. Another more legitimate reason is that a variable annuity offers investors more mutual fund families to choose from. "If a manager leaves, [the annuity holder] can move to another fund and have no commission cost," Evensky says. "That is a valuable benefit, particularly for an investor that's interested in the ability to switch between management." Yet another reason is the income guarantees offered by annuities, Evensky says.

Putting a VA in a 401(k)

DeGeorge argues that "it's perfectly appropriate" to place a deferred annuity in a tax-deferred plan like a 401(k) because of the insurance benefits it offers. He notes that annuities provide a death benefit that protects money going to the beneficiaries if the value of the investment portion of an annuity should decline. Annuities also offer living benefits that protect contract owners from a downturn in the market while they're still living. "You don't get those types of guarantees if you fund a 401(k) plan with only mutual funds," he says. "If the value of the mutual fund goes down, the fund isn't going to make up the difference; the insurance company offers various guarantees to make up the difference."

Reagan adds that insurers have improved variable annuities by creating more options, guarantees, and riders. "You can have annuities with no surrender charges, traditional surrender charges, and everything in between," he says. Because annuities have become more flexible, it should be easier for advisors to find the right annuity to fit the client's needs. But with the SEC and NASD looking over the industry's shoulders, advisors will need to be extra careful about every sale.

Washington Bureau Chief Melanie Waddell can be reached at [email protected].