Want a variable annuity that works?

Then look for one with low expenses.

As regular readers of this column know, I've been critical of variable annuities for many years. The basic reason is that the high expense burden of the most commonly sold variable annuities--- over 2 percent a year--- overpowers the benefits of tax deferral.

Lower the expenses, however, and a variable annuity can compete with both managed taxable funds and low cost, tax efficient, index funds.

I learned this from some research done at TIAA-CREF. While few people other than teachers are familiar with the Teachers Insurance and Annuity Association-College Retirement Equity Fund, the company has been providing variable annuities for decades. Only recently, however, was the firm been allowed to offer their annuities to the general public.

You can get some idea of this invisible organization's size by considering that their TIAA-CREF Stock fund sub-account has $133 billion in assets under management.

That's more than 10 times the assets of the next largest variable annuity sub-account and more than the $110.5 billion in assets of the world's largest mutual fund, Vanguard Index 500 or the $109.8 billion of Fidelity Magellan.

To test how the long-term performance of a low expense variable annuity would compare to both a taxable index fund and a managed fund in a conventional variable annuity, the TIAA-CREF researchers assumed that all funds had a gross return of 10 percent a year. They also made assumptions about the annual distributions from the taxable index fund to the effect that 32 percent of the annual return would be realized in taxable capital gains distributions each year. On those assumptions, we learn a number of things:

• The high expense variable annuity is a non-starter. It can't compete with either the index fund or the lower cost variable annuity.

• The low cost annuity pulls ahead of the taxable index fund in the 14th year. It has a substantial lead by the 20th year.

Long Term, a Low Expense Variable Annuity Wins After Taxes

Year TIAA-CREF VA index fund (0.37%) Taxable index fund (0.20%) VA Managed Fund (2.13%)
1 $10,664 $10,752 $10,657
5 $14,027 $14,485 $13,834
10 $20,404 $20,928 $19,084
15 $30,503 $30,212 $26,325
20 $46,495 $43,633 $36,315

Source: TIAA-CREF (assumes 10 percent annual gross return in all funds)

To check these figures I used an Excel spreadsheet I developed a number of years ago to do much the same thing. While not identical, my model shows the same general relationships--- for a long term holding, a low cost variable annuity will even beat a tax efficient but taxable index fund holding. It will certainly beat a high cost, tax inefficient managed fund.

Finally, the TIAA-CREF model assumes that all three investments are cashed out, with all taxes paid at the end of the measuring period. In fact, no one seeking long term tax deferral would actually do that so it's not a very fair comparison.

The real advantage of the low cost variable annuity comes during a long withdrawal period because you will have a larger sum from which you can make annual withdrawals. The pre-tax figures are shown in the table below.

The Low Cost Variable Annuity Wins Pre-Tax

Year TIAA-CREF VA index fund (0.37%) Taxable index fund (0.20%) VA Managed Fund (2.13%)
1 $10,963 $10,814 $10,710
5 $15,386 $14,609 $13,938
10 $25,078 $21,099 $19,228
15 $39,704 $30,471 $26,524
20 $62,891 $44,007 $36,589

Source: TIAA-CREF (assumes 10 percent annual gross return in all funds)

Now suppose that you were ready to use the money after 20 years and started taking 10 percent a year from your account. After twenty years you'd be able to take $6,289 from the low cost VA account and only $3,659 from the expensive variable annuity. (See what I mean about non-starter?)

Since you pay at the same tax rate on each the low cost VA has a clear advantage. Unless you were in the highest tax brackets, you would also have more after-tax income from the low cost variable annuity than from the taxable index fund.

Bottom line?

High expense variable annuities continue to be a poor choice.

A low expense variable annuity, however, will beat a tax-inefficient taxable managed fund and, eventually, a tax efficient taxable index fund. So if you want to make long-term investments without worrying about year-to-year tax bills, low cost variable annuities are a good choice. Better still, investors who already own high-cost variable annuities can improve their results by using a 1035 exchange to a low-cost product.

The best news?

The number of low cost variable annuities is increasing.