The worst retirement investment you can make

By Liz Pulliam Weston

By all rights, variable annuities should be dead by now.

A series of tax cuts seriously eroded this investment's main advantage of tax-deferred gains. Regulators have filed a series of enforcement actions against annuity sellers for unsuitable sales, lack of disclosure and churning.

Yet, variable annuities were on pace to post their highest sales ever in 2007, according to industry reports:

• Sales through the third quarter totaled more than $134 billion, on track to beat record sales in 2006 of $160 billion.

• Assets in variable annuities neared $1.5 trillion at the end of the third quarter in 2007, a 15% increase from the same period in 2006.

• The amount of "new" dollars flowing into annuity contracts -- as opposed to exchanges or transfers from one contract to another -- was up more than 45% in 2006 from a year earlier, leveling out in 2007.

"The new money coming into the industry has really shot up," said Rick Carey, managing director of research for the VARDs Report, a Finetre Corp. publication that tracks variable-annuity trends. "That is a very good indicator of the health of the industry."

But is it a good indicator of the financial health of the people who buy annuities? The revival in sales distresses variable-annuity opponents, who say the investment is rarely suitable for investors but is aggressively pushed by commission-driven salespeople.

"When you take the commissions out of the equation, the allure of a variable annuity disappears," said Miami fee-only financial planner Frank Armstrong, a former insurance agent and author of "The Informed Investor: A Hype-Free Guide to Constructing a Sound Financial Portfolio." "They cost a bundle," he added. "And the tax treatment (upon withdrawal) is horrendous."

A variable annuity, in case you're not familiar with the term, is an insurance contract that allows you to invest your premium in various mutual fund-like investments. Here are some key points:

• Tax treatment. Your gains in an annuity grow tax-deferred, but they are taxed as income when you withdraw the money. That contrasts with other investments such as stocks and mutual funds, which can qualify for lower capital gains treatments.

• Penalties for early withdrawal. Variable annuities are designed as retirement savings vehicles. So, you pay a 10% federal-tax penalty if you withdraw money before age 59½. Insurance companies typically levy surrender charges of their own if you withdraw more than 10% of your balance in the first few years. Surrender charges usually start at 7% of your investment and decline to zero over the next six to eight years. They can range, however, up to 16% and last for as long as 15 years.

• Death benefit. Variable annuities typically come with a death benefit that ensures your heirs get back at least as much as you invested if you're unlucky enough to die while your investments are down. Your heirs will have other problems if you die owning an annuity, however. While most other investments get favorable tax treatment -- a so-called "step-up in basis" that eliminates or drastically reduces the taxes heirs must pay when they sell -- withdrawals from an annuity are taxed at regular income-tax rates.

• Living benefits. Death benefits aren't the only insurance feature you can get with a variable annuity. Increasingly, insurers are pushing so-called "living benefits" or "life benefits," which guarantee that you can get back at least your original investment, usually compounded by a certain amount, when you withdraw the money in retirement. Investors stung by the bear market are greatly attracted to these guarantees, Carey said. That's helped fuel annuities' rise. Living benefits were available on 20 of the 25 top-selling variable-annuity contracts last year.

• Costs. The insurance features of an annuity aren't free, of course. The typical annuity with just a death benefit costs 50% to 100% more in annual fees than comparable mutual funds. Life benefits can add 20% or more to that cost.

Those extra expenses can seriously eat into your returns. Consider what would happen if you invested $5,000 a year in mutual funds with annual expenses of 1.5%, versus the same investment in an annuity with a 2.5% expense ratio.

Continued: A widening gap

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