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Approach variable annuity "bonuses" with caution

Sales of variable annuities (VAs) have soared, and so has the number of riders and options you can buy with them. You can get everything from long term care coverage to a guarantee that your investment will be protected from stock market slumps.

Bonus annuities

often have serious trade-offs, including higher fees and longer

surrender periods .

One of the most controversial features, however, is the "bonus credit." When you buy a VA with a bonus credit, the insurer gives you a bonus of generally 1 to 5 percent of your initial investment. Thus, your investment of $100,000 instantly becomes $105,000 if the insurer gives you a 5 percent bonus.

However, these bonus annuities often have serious trade-offs, including higher fees and longer surrender periods. Securities regulators, who are concerned that agents and brokers are not disclosing the downside of these bonuses to consumers, are now investigating the sales of annuities with bonus credits.

The feds are watching

Bonus products have become popular enough to attract the attention of the Securities and Exchange Commission (SEC). The SEC says it has been investigating bonus annuities for several months, although it will not comment on whether it is investigating particular companies, agents, or brokers.

Susan Nash, senior assistant director for disclosure and insurance product regulation for the SEC, says her agency is most concerned about the way bonus annuities are marketed. Nash says that a high volume of 1035 exchanges — exchanges that allow annuityholders to exchange insurance or annuity contracts without paying any tax penalty — has been reported to the SEC in the past year. This unusually high number of exchanges could mean many agents are persuading consumers to get out of their existing annuity contracts by enticing them with a bonus on a new VA, without disclosing any possible fees or surrender periods.

"There is no

one situation or set of situations in which a bonus contract

is always going to be suitable."

The SEC recently published an online brochure to educate consumers about VAs, with a section devoted to bonus products. "Variable annuities with bonus credits may carry a downside . . . higher expenses that can outweigh the benefit of the bonus credit offered," the SEC warns. "Before purchasing a variable annuity with a bonus credit, ask yourself — and the financial professional who is trying to sell you the contract — whether the bonus is worth more to you than any increased charges you will pay for the bonus."

However, some argue bonus products can benefit certain investors. W. Thomas Conner, vice president and general counsel for the National Association for Variable Annuities (NAVA), an industry trade group in Reston, Va., says that a bonus feature can help cover any surrender fee for a product a consumer may want to cancel — such as a fixed annuity earning a steady but low rate of interest, or a bank certificate of deposit (CD). Conner also says that the VA bonus can give consumers who are nervous about the stock market an extra cushion of comfort about their investment.

"Bonuses are like any other feature of a VA. They have to be analyzed in each individual circumstance," Conner says. "There is no one situation or set of situations in which a bonus contract is always going to be suitable."

Five shopping tips for bonus annuities

If you're thinking of buying an annuity with a bonus, make sure you consider the following factors:

Ask about extra fees

Obviously, an insurer cannot afford to give you money for free. It needs to absorb the cost of giving you a bonus, and it can do so in a variety of ways. It can cut the agent's or broker's commission, tack on extra fees, or extend surrender periods (periods when it costs you greatly to cancel your policy). Patrick Reinkemeyer, director of investment consulting at Morningstar Inc., which rates variable annuities, says some insurance companies add 0.15 percent more in mortality and expense fees to offset the bonus feature. Mortality and expense fees are what the insurer is charging you for the risk it is taking in the annuity contract.

Other companies will charge you separate fees for a bonus. For example, Nationwide Financial Services offers an Extra Value rider on its America's Future VA that gives you a 3 percent bonus on all deposits you make in the VA for the first year. It charges you 0.45 percent of your investment for the rider for the first seven years you own the VA.

If you plan to keep your money in the annuity for a short period of time, the benefits of the bonus may outweigh the extra fees. However, if you plan to keep your money in the annuity for an extended period, those extra fees may eat into your bonus and actually erase it.

Ask about longer surrender periods, greater surrender fees

Instead of increased fees, you may be hit with a longer surrender fee on your bonus VA. Jacob Herschler, vice president of VA marketing with American Skandia Life Assurance Corp. in Shelton, Conn., says there is an eight-year surrender period for his company's bonus VA, the Xtra Credit Variable Annuity, compared with the seven-year surrender period for its ASAP II VA, which is a more standard VA product. So if you decide before the eighth year you want to get out of your contract, the company will be able to hit you with a fee that pretty much guarantees it gets its money back from the bonus.

Instead of

extending surrender periods, some insurers increase surrender fees.

Instead of extending surrender periods, some insurers increase surrender fees. American Skandia will charge a 7.5 percent surrender fee if you cancel your ASAP II VA within the first year, 7 percent within the second, 6 percent within the third, 5 percent within the fourth, 4 percent within the fifth, 3 percent within the sixth, and 2 percent within the seventh. However, for its Xtra Credit VA, you will be hit with an 8.5 percent surrender fee if you cancel within the first four years, 7.5 percent within the fifth year, 5.5 percent within the sixth, 3.5 percent within the seventh, and 1.5 percent within the eighth.

It also pays to ask if surrender fees, surrender periods, and mortality and expense fees all increase simultaneously with a bonus product. For example, Equitable Life Assurance Society of the U.S. offers a bonus VA — the Accumulator Plus — that pays a 4 percent bonus for .05 percent more in mortality and expenses. In addition, it has a nine-year surrender period rather than the seven-year period you get with the standard Accumulator VA.

The Accumulator Plus also has a different surrender fee schedule than the Accumulator, in which the surrender fee goes from 7 percent to 1 percent through the first and seventh years, respectively. The surrender fee schedule for Accumulator Plus is: first year (8 percent), second year (8 percent), third year (7 percent), fourth year (6 percent), fifth year (5 percent), sixth year (4 percent), seventh year (3 percent), eighth year (2 percent), and ninth year (1 percent).

Also be sure to understand the sticky annuity language. Some companies give surrender fees rosy titles, such as "contingent deferred sales charges" (CDSCs), or "back-end sales loads." Regardless of what they are called, you will be charged if you walk away from your contract early.

Keep in mind that if you decide to surrender the annuity and collect your cash without putting it into another annuity from any insurer, you will have to pay a 10 percent IRS penalty tax if you are under 59½ and withdraw your annuity funds for any reason other than death or disability.

Weigh other features for your VA

Along with bonuses, variable annuities now offer a slew of features that can meet a variety of financial needs. You can buy an annuity with a long-term care rider that will pay for future nursing home care if you need it in the future. You can buy a guaranteed minimum income benefit (except in California), that guarantees that your monthly payments will be a minimum amount when you start receiving payments from your annuity, regardless of how the stock market performs.

"You have to ask yourself if the option you're buying is the one best suited for your needs."

Obviously, these riders cost money, so it's important to determine which ones you really need. If you're nervous about the stock market, or concerned that you won't have enough to pay for nursing home care in the future, you may be better off choosing a rider that can address those needs, rather than paying for a bonus that provides instant gratification but that may not be such a great deal in the long run. "You have to ask yourself if the option you're buying is the one best suited for your needs," says Arthur Fliegelman, vice president and senior analyst at Moody's Investors Service.

Some standard VAs offer features that aren't available on bonus VAs. For example, Hartford Life Insurance Co.'s Director VA has a "dollar cost averaging" feature in which you can get a fixed rate of interest of 10 percent for six months or 8 percent for 12 months. After that, you are required to put your money into subaccounts, which are a series mutual funds. Martin Swanson, director of marketing for Hartford Life's investment products, says dollar cost averaging feature is designed to ease investors' fears of investing in the stock market. Dollar cost averaging, however, is not available on Hartford Life's bonus VA, the Director Plus.

Make sure you have enough investment options

When you consider a bonus, don't forget the main feature of the VA: your investment subaccounts. If you are exchanging your VA for one with a bonus feature, make sure you aren't sacrificing the number of investment options, or the quality of those investments, according to Reinkemeyer, of Morningstar. "You have to analyze the product from an investment standpoint," he says. "You have to look at the breadth and depth of the investment offerings."

Reinkemeyer says that VAs with bonuses are not known to have more limited investment offerings, as options vary more by company than whether you have a credit or a rider on your VA. But you need to consider the investment options you're getting with any kind of annuity exchange. "If your investment options are better [with the new VA], good. But if they're worse, you really need to think about it," he says.

Think before you switch

One of the factors that prompted the SEC investigation into VAs with bonuses was the high volume of 1035 exchanges. Indeed, the promise of a bonus may tempt you to cancel your present contract.

But Cynthia Crosson, senior financial analyst for A.M. Best, the insurance ratings company, says that if you're happy with the performance of your investment, as well as the service you get from your company, you shouldn't let the bonus influence your decision to surrender your contract. "If someone is trying to move you from one contract to another, you have to ask a lot of questions," she says.

Crosson points out that annuities are generally for people who are not contributing the maximum amount to their retirement plan, such as a 401(k) or a 403(b). She warns not to let the enticement of a bonus prompt you to invest in an annuity when you can save money for retirement in much cheaper ways. "Annuitites are for someone who has a long-term horizon," she says. "You have to be cognizant of the fees that go along with them."

If you're thinking about buying a VA with a bonus feature, make sure you keep a tried and true phrase in mind: "There's no such thing as a free lunch."

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