Fixed Annuities Rival Municipal Bond Funds

They’re baaaack!

Fixed annuities, that is.

After a couple of years paying lackluster yields and generating little enthusiasm among investors, fixed-rate annuities are enjoying a modest sales boom. And that could mean trouble for municipal bond mutual funds.

Although the two types of investments aren’t normally compared in the same breath, they do share some key similarities: Both spin off tax-sheltered income and both appeal to a mostly conservative clientele.

Following the unsteady bond market of 1994, when muni funds tumbled about 6.5% on average even after factoring in their interest income, certain disgruntled shareholders might be ready to sell out if they haven’t done so already. For some investors, the next stop could be fixed or guaranteed annuities, so named because they feature price stability.

Several insurance companies are aggressively pursuing annuity investors with attractive yields, says James Rapisarda, a principal at Glass Financial in Phoenix.

He cites the Century 5 annuity from Sun Life Insurance Co. of America in Los Angeles that currently pays a 7.4% annual yield guaranteed for five years.

That figure is significant because “people don’t seem to respond to anything (in annuities) unless it’s in the 7% area,” Rapisarda says.

But before you cash out of your muni bond funds for fixed annuities, consider how the two products differ in terms of the following key traits:

* Risk. With muni bond funds, investors assume market dangers--the biggest of which is that interest rates will rise and bond prices will tumble, as happened in 1994. On fixed annuities, the issuing insurance company bears this risk, promising to pay the guaranteed yields no matter what happens in the financial markets. Insurers pay annuity yields from cash generated by their holdings of bonds, mortgages, stocks and other investments.

Unfortunately, insurers sometimes get squeezed and a few have gone into default. Investors could lose some yield income and perhaps even part or all of their principal. With annuities, a guaranteed return is only as good as the company behind it.

* Capital-gains potential. Muni bond funds appreciate when interest rates ease and bond prices rally, as happened in 1993, 1992 and 1991. There’s no such appreciation possibility with fixed annuities.

* Tax treatment. The interest spun off by muni bond funds is tax-free, while annuity yields are tax-deferred. When money comes out of the account, ordinary income tax rates apply on earnings.

What’s more, withdrawals from annuities (but not muni bond funds) could expose you to a 10% Internal Revenue Service penalty if made before age 59 1/2.

* Surrender charges. Most annuities attach back-end charges to discourage cashing out of contracts early. Such charges may start around 7% for withdrawals in the first year and phase down by one percentage point each year after that.

Certain muni bond mutual funds also carry front-end or back-end charges, but those are usually lower. Besides, many other fund companies impose no such costs, coming or going. These are true “no-load” products, although a few may have lower yields because of high expenses.

If fixed annuities still interest you after the preceding discussion, heed several pointers when shopping around.

First, of course, pay attention to the size and financial strength of the insurance company offering the annuity. Standard & Poor’s, Moody’s, Duff & Phelps and A. M. Best all rate insurers according to their credit standing.

You don’t have to buy contracts from the very top-rated companies you can find--especially since their yields might be a bit lower. But you should lean to firms graded in the top two or three levels by at least two or three of those rating agencies, suggests Hersh Stern, a principal at United States Annuities in Englishtown, N.J.

Similarly, don’t always chase after the highest yields, as an insurer might be hard-pressed to deliver an unrealistically generous rate. Annuity Shopper, a quarterly publication from United States Annuities, is one of several resources for comparing rates.

To diversify among insurance companies and to get a blending of rates and maturities, you might even want to “ladder” your portfolio, suggests Jerald Hampton, a Smith Barney executive vice president in New York. This would involve buying two or three annuities, each from a different issuer and with varying yields and guarantee periods.

Insurers typically require a minimum purchase of $5,000 or so on annuities, which makes it feasible for many smaller investors to buy more than one contract. Insurance companies, financial planners and brokerages (including many discounters) all sell these products.

Also keep in mind that you will have to make certain decisions with annuities that do not come up with muni bond funds.

For starters, you will in essence have to make an interest-rate bet in deciding how long to lock in a yield. After this guarantee period ends, which can occur in anywhere from one to 10 years, you must accept the insurer’s new rate or move elsewhere (which can be done on a tax-deferred basis). Annuities often come with a bailout clause that allows you to skirt the surrender charge if the new rate drops below a threshold.

Also, you will have to decide between contracts that allow you to put in money at any time--”flexible-premium” products--as opposed to those that require a lump sum or “single premium.”

And then there’s the need to choose among various payout options, such as income sent to you for a set number of years or for the duration of your life no matter how long in the tooth you get.

In terms of relating the movements of interest rates to bond prices and yields, muni funds may be harder for investors to understand than fixed annuities. But after that, the latter represent more complex products.

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Advertising mailers promoting mutual fund newsletters have been known to exaggerate, but they don’t usually offer contradictory advice. Yet that’s what Bob Duke, an investor in Newport Beach, noticed when he received the January, 1995, issue of Jay Schabacker’s Mutual Fund Investing and a friend handed him a January, 1995, promo piece for the publication.

Duke spotted eight funds that were simultaneously recommended for sale in the newsletter and for purchase in the mailer, or vice versa. At first, he thought the promo piece was a second version of the newsletter, as they share a similar masthead.

The explanation, said Schabacker Investment Management spokesman Ron Rough, is that the company producing the marketing piece was tardy about getting current advice. Specifically, the newsletter made some changes in January regarding its forecasts for interest rates and bond funds that weren’t incorporated into the mailer, Rough said.

Moral of the story: Read marketing pieces for investment newsletters with a grain of salt.

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If you recently moved to California or are thinking about leaving, request a copy of “State Tax Laws” a reference guide available free from the AARP Investment Program through Scudder. The publication lists each state’s policies regarding personal, sales, property and estate/inheritance taxes. Call (800) 322-2282, extension 8254, for a copy.

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Fixed Annuities at a Glance

Here is summary information on fixed-rate annuities--products offered by insurance companies that feature tax-deferred growth of income until money is withdrawn.

Tax-deferred income: Yes

Price stability: Yes

Different payout options: Yes

Different payment options: Yes

Limits on amount you can invest: No

Federal deposit insurance: No

Capital-appreciation potential: No

Choice of underlying investments: No

Company-imposed early withdrawal penalty: Possibly

IRS-imposed early withdrawal tax penalty: Possibly

Mandatory withdrawals: Typically, by age 85

Rate-guarantee periods: Typically, for 1, 3, 5, 7 or 10 years

Fixed Annuities at a Glance / Los Angeles Times