It's beyond all reason. Investors are still buying variable annuities. According to the National Association for Variable Annuities total product sales in 2004 were $130 billion. Total assets in variable annuity accounts hit $1.1 trillion.

Let's hear it for salesmanship!

A trillion dollars is a lot of money. It could be doing better elsewhere.

Yes, dear reader, Don Quixote Burns is back: I'm here to tell you, once again, that variable annuities are a marketed product. They make no sense for investors but lots of fees for the insurance industry and its sales force.

Let's start with history. We're going to measure the performance of variable annuity sub-accounts against the choice of Couch Potato investors everywhere, the Vanguard Index 500 fund. Over the 10 years ending April 30 some 1,669 variable annuity sub-accounts of all kinds had ten year histories. Only 111 of them---6.7 percent of the total--- did better than the Vanguard fund.

There were 930 sub-accounts that invested in domestic stocks. This group includes specialized funds that invest in real estate, energy, small and mid-cap stocks, etc. In that group 99--- or 10.6 percent of the total--- provided a higher return than the Vanguard 500 Index fund.

To get as close as possible to an apples-to-apples comparison, there were 193 sub-accounts Morningstar categorized as investing in "large blend" stocks--- the category of the Vanguard Index 500 fund. Only 9---or 4.7 percent of the total---provided a higher return than the inexpensive plain vanilla fund.

Conclusion: The odds of being among the handful of investors who did better in an expensive variable annuity product aren't very good.

But that isn't all.

While the insurance companies were charging more than 1 percent a year to provide the tax deferral wrapper, the pedestrian index fund was paying small dividends that required paying some taxes. Over the course of 10 years when the Vanguard Index 500 fund earned 10.19 percent compounded before taxes, you would have paid about $600 in income taxes on a $10,000 investment, reducing your return to 9.88 percent, according to Morningstar Principia. Note that the reduction in return is only 0.31 percent a year, less than a third of the 1 percent plus annual cost of merely deferring taxes.

Your reinvested dividends and capital gains, meanwhile, would have increased your cost basis to $13,380. Your ending market value would be $25,658. If you redeemed the entire investment you'd have to pay capital gains taxes (at 15 percent) on $12,277 of unrealized capital gains. This would leave you with about $23,800. That's an after-tax growth rate of 9.06 percent. Again, the reduction in return is only 1.13 percent--- about what insurance companies charge for the insurance wrapper that provides tax deferral.

You pay as much to merely defer taxes as you pay in actual taxes on the simple investment.

To do better than the Vanguard Index 500 fund after taxes, your variable annuity investment would need to have grown to $28,400 before taxes. Why? You'd probably be paying income taxes at 25 percent on your gain in the variable annuity investment. That calculates to an annualized pre-tax gain of 11 percent in the variable annuity sub account.

Was that done?


Only 5 of the 193 large blend sub-accounts returned more than 11 percent. In the larger universe of 930 domestic stock funds, only 59 did better than 11 percent. Only 64 of the entire universe of 1669 did better.

In fact, the odds of making a superior investment were much worse. Few investors were guided to those superior accounts by their trusted sales agent.

How do I know this? Simple: Most of the superior 59 domestic equity sub-accounts don't have much money in them. The ten largest contain less than $8 billion in assets. That's less than 1 percent of variable annuity assets. It's less than 2 percent of variable annuity assets in equity funds. (The next 10 largest funds have less than $1 billion in assets.) Since the winning domestic sub-accounts represent 6.3 percent of the choices but no more than 2 percent of the assets, the winners were under-selected by sales agent/advisors.

So what did the average investor actually experience?

The average and median returns, 7.29 percent and 7.24 percent, respectively, are a pretty good benchmark. An original $10,000 investment would have grown to $20,200 (at 7.29 percent), of which $10,200 was taxable gain. After taxes at 25 percent, you'd be left with $17,658.

That's $6,141 less than you'd have from the passive and taxable Vanguard Index 500 fund.

But that's just history. The future is worse.

Tuesday: Seven Reasons to Avoid Variable Annuities for the Future

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