Variable annuities are a triumph of marketing over arithmetic.
Yes, it’s time for my annual Variable Annuity Watch column and, as in every other year of testing, being simple and cheap has, yet again, been more rewarding for the majority of investors than being complex and tax-deferred.
In the unlikely event your life has been so incredibly blessed that no one has tried to sell you one of these products, a variable annuity is basically a mutual fund wrapped in an insurance contract. The insurance contract provides tax-deferral. As a consequence, your investment can grow without the impediment of annual tax payments on the return.
The basic contract has other goodies, such as a death benefit, as well. It guarantees that your designated beneficiaries will get your original investment, even if the value of the investment has declined. Except for the considerable inconvenience of being dead, most agree this is a nice benefit.
But rather than jump at the opportunity for tax deferral let’s go through the arithmetic. The problem with variable annuities is that their most important benefit, tax deferral, costs more than any taxes deferred. A typical variable annuity contract, according to Morningstar data, now has an average annual insurance cost of about 1 percent. It costs another 0.75 percent to manage the basic domestic equity mutual fund it may contain.
As a consequence, the insurance company skims 1.75 percent, or more, off the top of your gross return. It does this year in and year out. The 1.75 percent is a significant part of your return in a good year. It can be an annoying portion of your principal in a bad year.
So let’s ask a rude question. How does the insurance company do as a stand-in for the Internal Revenue Service?
Answer: It’s a shoo-in.
Over the long term, common stocks provide a compound return of about 10 percent a year, or so legend has it. Over the last 10 years the Vanguard 500 Index fund, which has current costs of only 0.17 percent a year, has provided an annualized return of 2.82 percent a year. This is better than 61 percent of its higher cost competitors.
If you had wrapped it in a variable annuity with an additional cost of 1 percent your annualized return would be about 1 percentage point lower. That is the equivalent of a 35 percent tax rate on the return as you earn it (1 divided by 2.82). In addition you would still be liable for deferred taxes, at ordinary income tax rates, when you took your remaining return from the account. Of course, this was a dismal period for the domestic stock market.
So let’s go back 15 years and capture some of those bubbly Internet days. Over that period the annualized return of the Vanguard 500 Index was 5.37 percent, implying a substitute tax rate of 18.6 percent (1 divided by 5.37). Again, that’s only the cost of deferring taxes: When you actually want some spending money, you will still be liable for the deferred income taxes on your net return.
None of this considers the additional cost of a managed domestic fund— that 0.75 percent— over the lower cost index fund. If you figure that difference, a total of about 1.58 percent, the insurance product cost is the equivalent of an immediate “tax” of 15 percent on an annualized return of 10.5 percent; a 25 percent “tax” on an annualized return of 6.3 percent; and a 28 percent “tax” on an annualized return of 5.6 percent.
Since 5.6 percent is greater than the 5.37 percent return index investors enjoyed over the last 15 years, the majority of variable annuity investors have paid more for the privilege of tax deferral than they would have paid in taxes— and they lost the preferred 15 percent tax rate on dividends and capital gains to get the privilege.
Here are the pre-tax return figures for different time periods:
- Vanguard 500 Index fund returned an annualized 1.97 percent over the last year, 14.01 percent over 3 years, a loss of 0.33 percent over 5 years and a return of 2.82 percent over 10 years.
- The average returns of 2,664 large blend domestic variable annuity sub-accounts was minus 1.75 percent over the last year, 12.84 percent over 3 years, a loss of 1.61 percent over 5 years and 2.09 percent over 10 years.
As you can see, a low cost index fund beat high cost tax-deferral from the get-go.