By Scott Burns

The best way to make it big in a variable annuity over the last ten years has been to die. Take that simple step, and the death benefit would provide your heirs with a sum equal to your original investment, no matter how much the market value of your annuity sub-account investments had gone down.

Is that cool, or what?

This is no minor matter. Since most equity markets declined over the last 10 years, the death benefit provision of variable annuity contracts has become a life saver, so to speak. Better still, if you die this year there will be no estate tax.

What a deal!

However, if you are one of those pesky people who prefers being alive, the news isn’t so good. Welcome to the 2010 Variable Annuity Watch report, the annual column in which I test an Occam’s razor solution— low-cost index fund investing— against the more complicated and more expensive alternative of variable annuities. (Occam’s razor is a scientific dictum that tells us the simple solution is generally the best.)

Domestic equities.

As investing periods go, the last 10 years has been a good time to bet against the simple solution of index investing. Usually, the Vanguard 500 Index fund can be counted on to beat about 70 percent of its managed competition. But in the 10 years ending June 30 that didn’t happen.

The average large blend variable annuity sub-account returned a full decade loss of 1.83 percent, annualized. The Vanguard 500 Index fund provided a pre-tax return of minus 1.67 percent and a 2.09 percent annualized loss after taxes. Ranked against the competition, the index fund would have placed 892 out of 1,997 sub-accounts that survived the 10 year period. So it beat only 55 percent of competing variable annuity sub-accounts. This is the worst showing in the entire time I have been doing this exercise.

The word “survived” is important here. Let me explain why.

I don’t have a figure for the number of variable annuity sub accounts that were quietly taken out and shot over the last ten years, but a look at what has happened in mutual funds over the last 5 years is instructive. According to the most recent Standard and Poor’s Indexes Versus Active Funds report only 64.33 percent of all large cap blend funds survived the last 5 years. Couple that with the corresponding period ending 5 years earlier, where only 63.66 percent survived, and it is reasonable to guestimate that about 35 percent of all large cap blend funds are still with us. So if the Vanguard 500 Index fund beat 55 percent of the funds that survived the period, it’s a pretty good bet that it would rank somewhere around the top 15 percent of funds that began the period.

This is not statistical hair-splitting. Failing to take into account the huge number of funds whose track records are quietly buried when they disappear is a time-tested formula for making managed funds look a lot better than they are.

International Equities.

The Vanguard Total International Index fund returned 1.42 percent annualized before taxes and 0.88 percent after taxes. The average international stock fund lost 1.97 percent. Here, simple investing would have ranked 38th among the 564 surviving international equity sub-accounts, or in the top 7 percent.

Balanced Funds.

Vanguard Balanced Index fund returned 2.38 percent before taxes and 1.63 percent after-taxes. The average balanced sub-account returned 0.74 percent before taxes. Ranked on a pre-tax basis, the simple index fund would have ranked in the top 17 percent of the surviving balanced fund annuity sub-accounts. The sub-account population in this category has also had a major die-back, so the actual performance ranking against funds starting the period would be still higher.

Intermediate Bonds.

Little money goes into variable annuity bond funds because investors know annuity expenses will do real damage to their returns. While the average surviving intermediate bond fund annuity sub-account returned 4.84 percent pre-tax during the period, the Vanguard Total Bond index fund returned 6.20 percent before taxes and 4.93 percent after-taxes. In other words, the index funds’ after-tax return was slightly better than the pre-tax accumulation of the average variable annuity sub-account.

Ranking the pre-tax accumulation of the index fund against the pre-tax accumulation of  surviving annuity sub-accounts, the Vanguard Total Bond index fund would have ranked 77th of 777 surviving funds with 10 year records, or in the top 10 percent. As in other categories, the number of funds that began the period is much larger than the number of funds that survived it. Again, survivor bias works to understate the true performance against investors’ choices at the beginning of the period.

Bottom line? The benefit of tax deferral is often an illusion due to the higher cost of most variable annuity funds.