"When voters pulled their levers and made Republicans the dominant party in Congress they may also have set in motion the death of an astoundingly popular investment product: tax deferred variable annuities.

Why?

Because part of the Republicans "Contract with America" is a promise to reduce the capital gains tax. A lower capital gains tax will turn tax deferred annuities into a product with a tax burden that outweighs the benefits of tax deferral."

— this column, December 6, 1994

Since then, insurance oriented financial planners have sold investors more than $120 billion in variable annuities, $49.3 billion in 1995 and another $72.5 billion in 1996. All those people now own a high expense financial product that has no reason to exist. Worse, the investors are trapped. If they redeem their shares they will have to pay a deferred sales fee to the insurance company.

Industry statistics indicate total variable annuity sales of $290 billion since 1990. Thats a lot of money and they are worrying about losing it. The loudest whistling in the dark came from Mark Mackey, president of the National Association for Variable Annuities. "It is too simplistic to say that variable annuity sales will suffer due to a cut in the capital gains tax rate.", Mr. Mackey said in a recent press release.

True enough.

But the Variable Annuities are still dead meat. Its not just a capital gain tax cut. Its also the new IRA Plus account. This offers more than 90 percent of all households an opportunity to invest up to $4,000 a year of after-tax income in an special IRA account that will compound tax-free.

Not tax-deferred. Tax-free.

Sadly, the case for variable annuities has always been a tenuous one in which insurance industry marketing exploited the growing tax phobia of the investing public. Skeptical?

Let me show you the numbers.

First lets look at a worst case for mutual funds versus a typical variable annuity. Suppose we invest in a naked mutual fund and the same fund wrapped in an annuity contract. Suppose also that both investments have the same pre-fees return, the 10.7 percent a year long term return of common stocks. The mutual fund has annual expenses of 1.43 percent, the average for domestic equity funds. This expense is subtracted from the return. The fund is unusual in that it realizes all gains every year.

The same amount of money invested in the same fund— but under a variable annuity wrapper— will have total expenses of 2.30 percent, the average for the industry. How will their results compare?

Mutual Funds vs. Variable Annuities: $10,000 Initial Investment**

Period Mutual Fund After 28% Taxes Annuity Before Taxes Annuity After Taxes
5 years $13,813 $14,006 $12,884
10 years $19,081 $19,616 $16,924
15 years $26,357 $27,475 $22,582
20 years $36,409 $38,480 $30,506

After 20 years, the variable annuity will have a small pre-tax advantage over the fully taxed fund— it will have accumulated to $38,480, an advantage of $2,071 over the unsheltered fund.

The best defense for the annuity? Few people pay all their taxes at once. Instead, they withdraw income over a long period of time. The monthly income from the annuity will be higher than the monthly income from the taxed mutual fund. A naked fund with somewhat smaller fees or a slower portfolio turnover rate, however, would better the variable product. Bottom line: the benefits of tax deferred annuities are slender, at best. They only work for the very longest term investors and at very high levels of annual returns and risks.

Now lets test the same variable annuity against the new tax law. Starting with the same fund, we first reduce the capital gains tax rate to 20 percent: the naked fund beats the annuity. After 20 years the naked fund will have grown to $41,820 with no deferred tax liabilities versus the $38,480 accumulated in the variable annuity before any tax liabilities are paid.

If we further assume that only 50 percent of all capital gains are realized in any year, the advantage of the naked mutual fund grows. For an index fund with only 50 percent of all gains realized annually, the advantage soars. Any reasonable combination of lower taxes, lower expenses, and lower turnover with a naked fund will make the most commonly sold variable annuities look silly.

How Taxes, Fees, and Turnover Affect Naked Mutual Fund Accumulations

Period Mutual Fund After 28% Taxes Mutual Fund After 20% Taxes Mutual Fund After 20% Taxes, 50% Realization Index Fund, 20% Taxes, 50% Realization
5 years $13,813 $14,300 $14,928 $15,707
10 years $19,081 $20,450 $22,285 $24,669
15 years $26,357 $29,244 $33,267 $38,747
20 years $36,409 $41,820 $49,661 $60,858

As I said, Variable Annuities are dead.

Sunday, December 4, 1994: Variable Annuity Controversy

Tuesday, December 6, 1994: Capital Gains Tax Cut Will Affect Variable Annuities

Correction: There was an input error in this column. The error double counted mutual fund expenses in annuities and reduced the values that would accumulate. Correcting the error improved comparative results for variable annuities but did not change the basic conclusion: reduction in the capital gains tax rate and introduction of the Roth IRA reduce the appeal of variable annuities substantially.

The figures below, from the corrected model, show pre and after tax accumulations in an average mutual fund and an average variable annuity and a Roth IRA over 5, 10, 15, and 20 year periods. As might be expected, the tax-free Roth IRA accumulates the most in any time period. Reductions in mutual fund expenses relative to the variable annuity or the rate of tax realization improve the figures for a naked mutual fund.

Investment Vehicles Compared

5 years

10 years

15 years

20 years

Naked Fund, after tax

$5,566

$7,837

$11,130

$15,904

V. Annuity, after tax

$5,293

$7,167

$9,883

$13,817

Fund in Roth-IRA

$6,034

$9,102

$13,731

$20,714

Questions about personal finance and investments may be sent to: Scott Burns, The Dallas Morning News, P.O. Box 655237, Dallas 75265; or faxed to (214)-977-8776; e-mail to scott@scottburns.com Check the website: "www.scottburns.com." Questions of general interest will be answered in future columns.