Put a couple variable annuity sub-accounts in a room and before you can say "Big Commission!" there will be more of them. Lots more.
At the end of February there were 22,380 variable annuity sub-accounts. That's a significant lead over the 14,181 mutual funds. The number of mutual funds, in turn, is double the individual stocks that trade in our public markets. All this is the proud accomplishment of the investment industry. They would like us to believe they only respond to wild market demand.
In fact, the drive to feed the marketing machine overwhelms logic, market demand, and investor need. The absurd rise of variable annuity fixed income investment accounts is a good example.
Ten years ago the entire variable annuity industry had only 283 fixed income sub accounts. The mutual fund industry had 449 taxable fixed income mutual funds. As recently as three years ago the number of mutual fund accounts still exceeded the available 1,777 fixed income sub accounts.
Today, 2,900 fixed income sub accounts far surpass the 2,377 taxable fixed income mutual funds.
|Fixed Income Variable Annuity Accounts vs. Taxable Fixed Income Mutual Funds|
|Time Period||Variable Annuity||Taxable Mutual Funds|
|Source: Morningstar, 2/28/02 data|
Unfortunately, these tax-deferred accounts don't make economic sense.
The fees charged by variable annuities cost more than the income taxes most investor's pay.
Here's the math. Investors are hard pressed to find yields much over 6 percent. If you paid taxes at a 30 percent rate your return would be reduced by 1.80 percentage points. Your net return would be 4.20 percent. That's a material concern for couples that have taxable incomes between $112,850 and $171,950. Singles with taxable incomes of $67,700 and $141,250 would pay taxes at the same rate.
If your taxable income is lower--- and that's the majority of households--- it's a real no-brainer. The variable annuity vendor costs more than the taxman. Worse, you still have to pay taxes on what's left.
In fact, some 1,530 of the 2,900 fixed income variable annuity sub accounts have total expenses of 1.80 percent or more. That's the equivalent of a 30 percent tax imposed by the investment vendor.
A whopping 1,803 fixed income sub accounts have annual expenses of at least 1.62 percent a year. That's the equivalent of the 27 percent tax rate couples pay on taxable incomes of $46,700 to $112,850 and singles pay on taxable incomes of $27,950 to $67,700.
More important, taxes on the remaining income are only deferred. They are not eliminated. You pay taxes when spend some of your accumulated investment income.
So let's do a little more math.
Suppose you are in the 30 percent tax bracket, that bonds are yielding 6 percent, and that you invest in a fixed income sub-account that costs 1.8 percentage points a year. You'll net 4.2 percent. It will accumulate tax deferred. If you let it accumulate for 15 years an original investment of $10,000 will grow to $18,536. When you withdraw your $8,536 in accumulated income it may be taxed at 30 percent, reducing your spendable return to $5,975.
That's the equivalent of a net compound return of only 3.17 percent. In effect, the combination of variable annuity fees and eventual taxation works out to an effective tax rate of nearly 50 percent.
Now lets assume you'll be in the 15 percent tax bracket when you spend your accumulated money. Then your spendable return will be $7,256. Your net return will be 3.70 percent. That works out to a tax rate equivalent of 38 percent.
According to the tax table, 38.6 percent is the highest rate you can pay. It's what couples and singles pay on taxable income over $307,050.
Bottom line: variable annuities aren't purchased; they are sold for the benefit of the vendor and its sales force.