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Carefully consider whether you need a variable annuity

Lately, conservative investors have flocked to variable annuities. But as I see it, sales ought to be slumping and the only buyers should be young cheapskates and graying gamblers.

Yeah, this takes a little explaining.

Variable annuities offer the chance to get tax-deferred growth by investing in a menu of mutual funds. Wrapped into that package is insurance that ensures your heirs will get more than the account's current value, should you have the misfortune to die and also fare poorly with your investments.

According to the National Association for Variable Annuities in Reston, Va., these oddball investments pulled in a net $13.2-billion in 2003's third quarter, the latest period for which data are available. That was up from $8.1-billion a year earlier.

Yet, if anything, variable annuity sales ought to be drying up. Why? For starters, the 2003 tax law dented their allure, by making taxable-account investing more attractive.

Sure, a variable annuity gives you tax-deferred growth. But withdrawals are taxed as ordinary income, which means you could lose as much as 35 percent to Uncle Sam. By contrast, if you invest through a taxable account, your dividends and long-term capital gains are dunned at a maximum 15 percent.

"The change in capital-gains and dividend tax rates should have gutted sales of these things," says Jeffrey Brown, finance professor at the University of Illinois at Urbana-Champaign.

Even before last year's tax law, variable annuities were a dubious proposition. According to Chicago's Morningstar Inc., if you buy stock and bond funds through a variable annuity, you will pay average annual expenses equal to a hefty 2.28 percent of assets. A big reason for this high cost is the 1.18 percent average "mortality and expense" charge.

This insurance guarantees a minimum death benefit. Some variable annuities simply promise that your heirs will get back the amount you invested, in the unlikely event you lose money on the account during your lifetime.

Other death benefits are more generous. For instance, some variable annuities promise that your heirs will get back at least the amount you invested plus maybe 5 or 7 percent in annual interest. Others will pay your heirs the account's "highest value," with that high value determined as of a particular date each year. These rising death benefits might cap out at, say, age 80 and they will be reduced, if you withdraw money from the annuity.

Such guarantees have proved to be a big selling point with conservative investors. "These things are now being marketed as downside protection," says Moshe Milevsky, a finance professor at Toronto's York University.

Yet the insurance is no bargain. Consider a study by Milevsky and Steven Posner that appeared in the March 2001 Journal of Risk and Insurance. The authors calculated that, if you are age 30 and own a variable annuity that promises to pay your heirs at least the amount you invested, the insurance is worth less than 0.01 percent a year.

On the other hand, if you are a 65-year-old man with an annuity that guarantees your heirs the high-account value, the insurance might be worth 0.63 percent a year. But even then, this insurance is worth far less than the average 1.18 percent mortality charge.

Despite these daunting drawbacks, I can think of a few situations where variable annuities might make sense. Let's start with our young cheapskates. Suppose you are 30, you are maxing out on your 401(k) plan and individual retirement account and you want to sock away additional money for retirement.

True, if you stash dollars in a variable annuity, your gains eventually will be taxed at income-tax rates. But the decades of tax-deferred growth should compensate.

To make sure you get decent growth, however, look to minimize investment costs. That means sticking with low-cost variable annuities, such as those offered by New York's TIAA-CREF and Vanguard Group in Malvern, Pa.

While our young cheapskates aim to get the most out of the tax deferral, our graying gamblers want to get the most out of the insurance. Suppose you are age 65 and your life expectancy isn't that great.

You might purchase a variable annuity that promises to pay your heirs at least the amount you invested plus 7 percent interest. You can then roll the dice, investing your entire variable annuity in, say, an emerging-market stock fund. Even if the fund bombs, your heirs will get back your original investment plus 7 percent a year.

The healthy also can play this game. Mark Cortazzo, a financial planner with Macro Consulting in Parsippany, N.J., encourages clients near retirement to buy variable annuities that have an income rider, such as Equitable Life's Accumulator Elite and ING Group's GoldenSelect. Clients can convert these annuities into a minimum stream of income, no matter how their funds perform.

Cortazzo, of course, hopes the funds will fare well. Problem is, the expenses on these annuities are steep. "If you did a conventional asset allocation with 60 percent stocks and 40 percent bonds, the costs would be tough to overcome," he says. "But we don't use them in a conventional way."

Instead, he has clients invest their annuity money in funds focused on emerging-market stocks, technology shares and small-cap companies. If these risky bets pay off, Cortazzo's clients can cash out after three or four years without any surrender charges. What if the funds flop? They can always hang on and take the guaranteed income.

_ Wall Street Journal