The enthusiasm of the sales force continues. But the investing public is having second thoughts.

Yep, you guessed it.The topic is my favorite useless investment product: the variable annuity. According to the National Association of Variable Annuities, premium flows barely budged in 2005 over 2004. Sales rose from $131.7 billion to $133.4 billion, a nominal increase.

The real action, however, was in net flows. That's the net new money investors added after subtracting redemptions and withdrawals. There, net new flow was cut in half. It plunged from $40.2 billion to $20.5 billion.

By now virtually everyone knows that the vast majority of variable annuities carry additional expenses--- most are well over an added one percent a year. They also know this additional expense has the same effect as a tax, reducing returns.

By now, virtually everyone knows the added expense burden of variable annuities makes them poor choices for fixed income investments. If bonds are yielding 5 percent and you pay an average of 1.35 percent in insurance expenses, you are paying 27 percent of your gross return, today, in order to defer income taxes until tomorrow.

By now, virtually everyone knows that variable annuities investing in equities have a tax disadvantage compared to stock or equity mutual fund investments. Dividends in a variable annuity, when withdrawn, are taxed at ordinary income rates. Dividends from an individual stock or mutual fund are taxed at 15 percent. Capital gains in a variable annuity, when withdrawn, are taxed at ordinary income tax rates. Long-term capital gains in a stock or mutual fund are taxed at only 15 percent.

Add the burden of the additional insurance expense, about 1.35 percent for the average domestic equity sub-account according to Morningstar, and any advantage to tax deferral is lost at the get-go. You can see the variable annuity cost disadvantage in a quick examination of the Morningstar database for mutual funds and variable annuity sub accounts. Over the ten years ending May 31, 2006, the average large blend mutual fund provided an annualized return of 7.27 percent. The average large blend variable annuity account provided an annualized return of only 5.95 percent. The 1.32 percent difference is about the same as the added 1.36 percent insurance charge added to the cost of the average variable annuity large blend equity account. It's also the equivalent of an immediate tax of 18.7 percent for the time period. (The table below compares the two universes over different investment periods.)

When It Comes To Distance, the VA Horse Trails the Pack
This table compares the performance of a major index fund, the large blend mutual fund average, and the large blend variable annuity account average over four different time periods. The performance disadvantage is virtually identical to the cost disadvantage of the average variable annuity account.
Last 12 mos.
Last 3 years
Last 5 years
Last 10 years
Vanguard 500 Index
Avg. Large Blend MF
Avg. Large Blend VA
Avg. VA vs. avg. MF
Avg. LB VA vs. V500
Source: Morningstar Principia, 5/31/06 data
So what happens over ten years, the long term you're supposed to use to best benefit from tax deferral?

You'd have more money in the average equity mutual fund than in the average variable annuity equity sub account--- and that's before paying higher taxes on the accumulated gain in the variable annuity.

My favorite way to benchmark this, which I've been doing for years, is to race a simple, no commission, no penalty, low-cost investment in the Vanguard 500 Index fund against the entire stable of comparable variable annuity accounts.

When we do that, we find that a $10,000 investment in the index fund would have grown to $21,556.70 over ten years, after payment of $466.31 in taxes and reinvestment of $2,936.55 in dividends and capital gains distributions. This leaves the fund investment with an unrealized long term capital gain of $8,620.15 and an unpaid tax liability of $1,293.02, assuming a 15 percent capital gains rate. The net, after-tax return calculates to 7.32 percent for the period. The index investor would walk away with a net of $20,263.68.

To beat that, an investor in the 25 percent tax bracket would need a pretax variable annuity return of 9.76 percent. That's way, way over the average return of 5.95 percent.

Instead, the average large blend variable annuity sub account would have grown to only $17,824.18 before taxes and only $15,868.13 after-taxes.

Indeed, in the entire stable of the 1,743 large blend variable annuity accounts with 10-year track records, only 37 beat the simple, out-of-favor index. That's the equivalent of a 50 to 1 a one long shot.

On the web:

The Variable Annuity Watch Reader includes more than 10 years of columns on this topic

The Investment Growth Horse Race On-Line Calculator