When the 403(b) was first created in 1958, annuities were the only investment option allowed. In 1974 Congress added paragraph 7 to the plan, creating the 403(b)(7) custodial account and opening the way for investment in mutual funds. However, more than 30 years later, close to 80% of all 403(b) money still sits in annuity investments. While a smaller percentage of 457(b) assets is in annuities, it's still an issue. Is it wise to invest 403(b) or 457(b) money in annuity products?

Annuity basics
An annuity is a contract with an insurance company. Two kinds of annuities exist: fixed and variable. Fixed annuities operate much like a certificate of deposit and come in three basic flavors: traditional fixed, two-tier, and equity-indexed. Variable annuities are simply mutual funds with an insurance wrapper. This allows the investments to grow tax-deferred.

While tax-deferred growth is nothing to sneeze at, there are other, less-expensive ways to get such benefits. Even Michael DeGeorge, vice president general counsel of the National Association for Variable Annuities (NAVA), said in a March 2004 appearance on CNNfn's Your Money program that annuities are right only for people "who have maxed out first in 401(k) and other qualified plans." Such plans include the 403(b) and 457(b).

This sentiment is echoed by Gary Schatsky, president of the Objectiveadvice Group and a fee-only financial advisor. He says that annuities usually only make sense for a very select group of wealthy investors who are in a high tax bracket and are in possession of a significant amount of cash they need to tie up.

Certified financial planner Scott Dauenhauer, president of Meridian Wealth Management, says: "Variable annuities make very, very little sense. I think some fixed annuities have a place inside a retirement account. The challenge is finding the right product. That would be one that has a fair rate of interest and a reasonable surrender period or no surrender period at all."

The knock on variable annuities
What's so wrong about variable annuities? Here are three of the biggest offenses:

  1. Exceptionally high fees. The annual cost of owning an annuity can be up to eight times more expensive than the fees charged by mutual funds.

  2. Dubious insurance component. To take advantage of this "benefit," two things must happen: You must die, and the market must have dropped. Even if these two events occur, you can protect beneficiaries much more affordably by purchasing low-cost term insurance. If you die and the market has not declined, you are now dead and have paid a hefty fee for a "benefit" that is worthless to your survivors. With term insurance, your heirs benefit whether the market goes up or down.

  3. Surrender charges. If you change your mind about the annuity, you'll have to pay a penalty for moving your money. These charges are quite high in the beginning -- such as 7% within the first year of investing -- but decline over the years (though it may take as long as a decade).

If annuities are so bad, why are they so prevalent in 403(b) and 457(b) plans? Blame an aggressive commission-based sales force, a lack of employee understanding, and a lack of employer oversight.

In particular, agents push the tax-deferred benefits of annuity products. However, the 403(b) and 457(b) are already tax-deferred vehicles. No further tax benefit is achieved by investing 403(b) and 457(b) money in an annuity. Also, be wary of those touting the loan provisions of annuity products.

Low-fee 403(b) and 457(b) products
Fixed annuities with a fair rate of return and a reasonable surrender charge, and no-load mutual funds from the likes of Fidelity, T. Rowe Price (NASDAQ:TROW), and Vanguard, can be attractive, low-cost options. Loaded mutual funds (i.e., those that charge commissions) can be just as expensive as high-fee variable annuity products. The notable exceptions to high-cost annuities are annuity products from TIAA-CREF. With fees that are among the lowest in the financial service industry and the absence of surrender charges, a fixed or variable annuity from TIAA-CREF can be just as affordable as a low-cost, no-load mutual fund.

The deadline for making a 2003 contribution to an IRA is April 15 -- just days away! Visit the Fool's IRA Center for details on this tax-saving, wealth-building gift from Uncle Sam.

Dan Otter is an adjunct professor at American University in Washington, D.C. In addition to operating 403(b)wise and 457(b)wise, he is the co-author of The 403(b) Wise Guide , a book that Vanguard founder John Bogle calls "right on!"