Variable annuities are not dead. They arent even injured. Why, they arent even bruised.
Such are the recent declarations from NAVA, the National Association for Variable Annuities, and LIMRA International, an insurance industry research organization. The announcements came in response to what may be the most mislabeled piece of legislation in history, The Taxpayer Relief Act of 1997. Passage of the bill, affectionately known among accountants as the Accountancy Lifetime Employment Act, sent shares of H & R Block to a new record high.
Among the goodies in the bill: a long awaited reduction in the capital gains tax, reducing the maximum rate from 28 percent to 20 percent for those in the 28 percent tax bracket or higher and still lower for those in the 15 percent tax bracket.
That reduction, however, also changed the playing field for investing, particularly for one of the fastest selling products around: variable annuities. When you buy a variable annuity what you get is an insurance contract wrapped around a mutual fund. The combination allows you to defer taxes on all income until you make a withdrawal. Then, in what financial types call the distribution period, all income is taxed at ordinary income rates.
Including capital gains.
And therein lies the problem. When you add the cost of the annuity wrapper (an average of 1.27 percent a year ) and contemplate paying ordinary income taxes at 28, 31, or 36 percent instead of 20 percent on capital gains, logic starts to speak to you.
It says, "Maybe the costs absorb the benefit of tax deferral." Certainly, thats what my modeling told me when I declared VAs dead in August.
Reality testing says the same thing, witness the 15 year test of actual variable annuity contract results against an identical investment in the Vanguard Index 500 fund done in this column on September 14.
Not so, a recent LIMRA International press release declares: "Impact of Capital Gains Tax Reduction on Variable Annuities Is Minimal."
The National Association for Variable Annuities says much the same but backs it with an accounting firm study: "Price Waterhouse Finds Variable Annuities Remain Very Attractive Retirement Savings Option: study finds little impact of capital gains tax changes."
Variable annuity salesmen will probably quote the executive summary of this report frequently. Let us hope that they take the time to read the entire report and examine the assumptions in the Price Waterhouse model. In case they dont, here are some details you should know about the study and its assumptions:
- That the investor was in the 28 percent tax bracket while accumulating but in the 15 percent tax bracket during distribution. While there was a time when it was safe for investors to assume they would retire to a lower tax bracket, that time is long gone. Many people now assume they will be in the same basic tax bracket when they retire. Millions will be in higher tax brackets when the taxation of Social Security benefits is considered. This single Price Waterhouse assumption virtually wipes out any benefits of a 20 percent capital gains tax.
- That the normal holding period for an investor in a mutual fund was about five years so that 20 percent of all capital gains were realized in any given year, regardless of what the fund distributed. This basically eliminates long term tax deferral for the taxable mutual fund investor, increasing the cost burden of taxes on the account.
Small wonder Price Waterhouse found that variable annuities, broadly speaking, could typically recoup their added costs in only about one year compared to investment in a taxable mutual fund.
The problem here is in the "broadly speaking." If you read the report fully and examine the data, you find some very different observations. Here are a few:
- Their "base case" for all funds— the one displayed in the executive summary— shows that it only takes about a year for a variable annuity to catch up with a taxable fund. The base case includes balanced funds, bond funds, and specialty funds. This works to dilute any potential capital gains contribution with taxable interest income. The figures change dramatically when you look at an equity fund to equity fund comparisons.
- The break-even period for an annuity versus a low cost no-load growth fund has grown from 1.4 years to 5.6 years. And that doesnt include any deferred loads if you sell early.
- The break-even period for a variable annuity versus a low turnover, no load growth mutual fund has increased from 4.4 years to 14.6 years.
- The break-even period for a variable annuity versus a deferred-load growth fund if you are in the 28 percent tax bracket during both accumulation and distribution grew from 6.9 years to 11.7 years.
The bottom line for you and me as investors?
The Taxpayer Relief Act of 1997 has changed the playing field for investment products. It has made capital gains income more attractive. It has increased our incentive to seek capital gains. This means variable annuities are less attractive relative to vehicles that can provide capital gains income.
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 firstname.lastname@example.org. Check the website: www.scottburns.com. Questions of general interest will be answered in future columns.