Ask the Expert ~ Annuities vs. Municipal Bonds

This doc understands municipal bonds and is happy with the returns they've generated, but wonders if he should be diversifying his portfolio with annuities. Whether he should depends on how they would fit into the overall asset allocation.

Many companies have been trying to sell me annuities. I have about $2 million in stocks and mutual funds and around $800,000 in municipal bonds. I understand municipal bonds and have been happy with the returns. The question is should I be diversifying my portfolio with an annuity and if so which type?

Tom Orecchio - Physician's Wealth Manager

There are multiple issues that you should consider when evaluating an annuity as part of an investment strategy. Based on your question, it appears the product that is being offered for sale to you is a variable annuity.

The primary issue for your consideration is to understand how the annuity would fit into your overall asset allocation. From an investment perspective, variable annuities have sub accounts that are similar to mutual funds. From an insurance perspective, variable annuities can provide some insurance protections like a death benefit, typically the greater of the value of the annuity or your cumulative deposits. Some annuities also offer guaranteed withdrawal benefit (GWB) riders or other insurance provisions to protect your ability to withdraw an income for life. But, these features come at an additional cost.

The other important issues to consider before purchasing a variable annuity are fees and flexibility. Annuities have a variety of expense layers which include mortality and expense fees, and the annual operating expenses of the sub accounts. A high cost annuity can run in the range of 2.5% of total expenses a year, where a low cost mutual fund will cost about 0.5% or less. We would recommend you inquire about the flexibility to gain access to the money if you need liquidity.

Two final issues for your consideration are financial strength of the insurance company and compensation conflicts of interest of the insurance broker marketing the annuity. As with other insurance products, annuities are guaranteed by the issuing insurance company. You should check out the ratings and financial strength of the insurance company that you are considering. Finally, the person selling this product will often make higher commissions on the sale of the annuity than he or she would if they sold you a mutual fund. This presents them with a conflict of interest and may mean that this product is not in your best interest.

The main selling attraction of a variable annuity is its tax deferred status. Investments inside the variable annuity grow tax deferred. For an investor in a high tax bracket, this can be an attractive feature. However, there are drawbacks. In addition to the relatively high cost of annuities, the tax treatment of withdrawals is ordinary income, not capital gains. As long as there is a difference in the capital gains rate (currently 15%) and your ordinary income tax rate (likely higher), then this tax treatment is not ideal. While you are benefitting from the tax deferral, the ordinary income tax treatment of withdrawals negates some of the tax deferral benefit. Further, if you are in a low income tax bracket, you should rethink the need for tax deferred investments like variable annuities or even tax exempt investments like municipal bonds.

To sum up, if the purpose of the variable annuity is to improve the diversification of your portfolio, then we would recommend you consider low cost mutual funds instead of an annuity. Mutual funds can be used to build a broadly diversified tax efficient and cost efficient portfolio.

It should be noted that we recommend that you complete a comprehensive financial plan before making decisions about how to structure your portfolio. This will help you to better understand your financial situation so that you may make more informed financial decisions.

This information and content is offered for informative and educational purposes only. The authors are not acting as Registered Investment Advisors, Investment Counsels, Tax Advisors, or Legal Advisors.