Variable Annuity Watch, 2008Variable annuities have a tough row to hoe. Doomed to being measured against better alternatives, they simply can’t overcome the burden of their fees or the higher tax rates investors must pay on their returns. The last year has been no exception.

In spite of these disadvantages, a hard-working sales force trudges on and racks up big-time sales--- $41.6 billion in the first quarter of this year. The sales for the quarter brought the total assets in variable annuities to nearly $1.4 trillion.

That’s a lot of retirement savings.

And there’s the rub.

Variable annuities transfer enormous amounts of spendable investment returns from investors to the insurance industry and its sales force. Using the alternative that I have suggested for years--- low-cost and tax-efficient index funds--- would save the investing public billions of dollars. With an average cost difference of about 1.8 percent a year, a cool $25.2 billion a year is fattening the insurance industry rather than investors.

Promises of tax deferral and expert management notwithstanding, variable annuity sub-accounts (the individual funds that investors choose inside the insurance contract) continue to trail a simple index. They did this in the worst period for index investing that I can remember. Over the last 3 and 5 year periods, respectively, the Vanguard 500 Index fund has beaten only 52 and 53 percent of its actively managed mutual fund peers. It typically beats about 70 percent of its actively managed peers.

So here is the investment score.

Over the 10 years ending June 30, the Vanguard 500 index fund (ticker: VFINX) returned 2.81 percent annually, while the average domestic, large-blend variable annuity sub-account returned 2.02 percent. Vanguard’s Total International equity fund (ticker: VGTSX) returned 6.94 percent, compared to 6.31 percent for the average international equity sub-account. And Vanguard’s Total Bond fund (ticker: VBMFX) returned 5.42 percent, compared to 4.06 percent for the average managed sub-account that invested in bonds.

The odds of having an adviser who could pick a winning fund improved over previous years. But they are still seriously against you. With only 1,318 of 5,488 large-blend sub-accounts beating the Vanguard 500 Index fund, you had only a 24 percent chance of doing better than the index. In international sub-accounts, only 2,796 of 7,555 beat the Vanguard Total International fund, so you had only a 37 percent chance of doing better. And in fixed-income, only 129 of 2,329 sub-accounts beat the Vanguard Total Bond fund, so you had only a 5 percent chance of doing better.

Basically, the deck is loaded against the investor.

Variable Annuity Sub-Accounts Trail Index Fund Alternatives

This chart compares the returns of the average variable annuity sub-account in three major asset classes with the returns of a simple index fund for the same asset class. In all cases, the index fund has done better over all four time periods considered.
Investment Last 12 mos. Last 3 years Last 5 years Last 10 years Expense ratio
Category: Large Blend Domestic Equities
Vanguard 500 (13.19) 4.28 7.45 2.81 0.15
Avg. LB VA (13.87) 3.52 6.75 2.02 2.05
Category: International Equities
Vanguard Total International (8.06) 14.94 18.33 6.94 0.27
Avg. International VA (9.03) 12.77 15.68 6.31 2.27
Category: Fixed Income
Vanguard Total Bond 7.23 4.02 3.77 5.42 0.19
Avg. Intermediate Bond VA 3.41 2.19 2.49 4.06 1.80

Ironically, these figures make the performance of variable annuity investments look better than they really are.

Why?  They don’t consider taxes.

When you invest in equities directly, dividends and capital gains are taxed at a maximum of 15 percent. Put the same investment inside a variable annuity contract, and the accumulated dividends and capital gains will be taxed as ordinary income upon withdrawal. Calculate what you’d have after paying taxes, as I did using Morningstar Principia, and only 12.4 percent of all variable annuity, large-blend sub-accounts did better than the Vanguard 500 Index fund over the last 10 years.

It would be different for bond funds, right?

Yes, but no.

Had you invested $10,000 in Vanguard Total Bond fund ten years ago, you would have earned 5.42 percent annually--- before taxes. Paying taxes each year at a 25 percent rate would have taken your return down to 4.05 percent, free and clear. Your account would be worth $14,871.

The average variable annuity bond sub-account earned 4.06 percent, before taxes. So the same investment would be worth $14,888 before taxes--- and $13,666 after taxes. That’s $1,205 less than the investment that had no tax deferral.

How can this be? Simple: High fees and tax disadvantages.

On the web:

Scott Burns’ columns on annuities

Variable Annuity Watch, 2007

Variable Annuity Watch, 2006

Variable Annuity Watch, 2005

Variable Annuity Watch, 2004

Liz Pulliam Weston on “The Worst Retirement Investment You Can Make”

Most recent industry sales and asset allocation data