The Motley Fool: Fixed annuities usually better deal than variable

Don’t invest in variable annuities without understanding them. Though they’re technically insurance products, they’re often promoted as investments – specifically, retirement savings vehicles with returns that “vary” according to how you invest the assets. Here are some things to know:

“Investments in variable annuities do grow tax-deferred. But tax rates are low these days, and the money you ultimately withdraw will be taxed at income rates, not the lower rates for dividends and long-term capital gains. Also, you can get tax-deferred growth from 401(k) plans or traditional IRAs, possibly along with a tax deduction.

“When you buy into an annuity, be prepared to stick it out, or get stuck. Try to withdraw your money within the first few years and you may face “surrender” fees of 7 percent or more. On $100,000, that could total $7,000. Also, withdrawing before you turn 59 1/2 will generally result in hefty penalties.

“Annual fees for variable annuities are typically between 2 percent and 3 percent. If your annuity is worth $100,000 and you’re paying 2.5 percent in fees, you’ll be forking over $2,500 per year. Ouch!

“The insurance component (the so-called death benefit) may not be as exciting as it seems. (For one thing, you must be dead to receive it.) Usually, your heirs will receive (1) what you put into the annuity, (2) its current value, or (3) a “stepped-up benefit” based on the value of the account on a certain date – whichever is greater. If that value was locked in when the market was at record highs and you die before the market recovers, then the insurance pays off for your family. Otherwise, the feature makes more money for the insurance company than for you.

Fortunately, there are some companies, such as Vanguard (877-662-7447) and T. Rowe Price (800-225-5132), offering low-cost annuities without surrender charges. For most people, it’s best to max out 401(k) plans and IRAs before thinking about variable annuities. Fixed annuities are also often better deals. Learn more at www.sec.gov/investor/ pubs/varannty.htm and at www.fool.com/retirement.htm.

Ask the Fool

Q: What should I do if the stock market crashes? – F.R., Miami

A: First off, don’t panic. Remember that the market always has its ups and downs, and sometimes the moves are big. This is why you shouldn’t have money in stocks that you’ll need within, say, five (or better still, 10) years. In the near term, anything can happen, including a crash. Over the long run, though, the market has recovered from all of its crashes and has gone on to set new highs – eventually.

So brace yourself for inevitable downturns. Know that while your $3,000 investment might grow to be worth $5,000 within a few years, it might also drop to $2,400 in short order. Over the long haul, though, if the company is healthy and growing, the stock price will catch up to the company’s worth.

Market crashes have a big upside – they can offer terrific bargains. Warren Buffett has recommended being fearful when others are greedy, and greedy when others are fearful.

Q: How can a firm’s earnings per share rise when its earnings are flat? – I.B., Garden City, N.Y.

A: It happens when the share count shrinks. Imagine that Carrier Pigeon Communications (ticker: SQUAWK) has 10 million shares outstanding and earns $30 million in a quarter. Its earnings per share (EPS) is $3.

If it spends some of its cash to buy back a million shares and then earns $30 million again in the next quarter, its EPS has suddenly risen to $3.33 (30 million divided by 9 million equals 3.33).

Companies buying back shares can be good – as long as the shares aren’t bought at inflated prices.

The remaining shares will be worth more.

My smartest investment

I bought stock in Ventana Medical Systems back in March 2006. The stock was trading at about $42 per share. I bought only $500 worth, to start. By mid-2007, the stock shot up over $75 per share, due to a possible merger with another company. Unsure whether I should sell, buy or hold, I decided to sell part of my shares to lock in a profit – of around $400! My remaining shares have since soared past $85 per share. I’m waiting for the stock to drop back down to buy more. Not bad for my first stock purchase! – Daniel Garland, Tucson, Ariz.

The Fool Responds: Congratulations. Many people like to lock in a profit when they can. It can make a lot of sense, though, if the company is still firing on all cylinders, and if it still seems undervalued, you may want to hang on.

Regardless, ask yourself which stocks seem the most promising to you, and park your money in them, not in companies in which you have half-hearted faith.