Tuesday, February 2, 1999

At the risk of a bracing supply of hate mail from the folks who sell them, I thought you might be interested in another simple test of variable annuities.

The basic selling premise for variable annuities is that you, poor burdened taxpayer, are fighting a losing battle with your investments. With Uncle Sam taking 20 to 39.6 percent of your investment return you need the tax deferred accumulation of a tax deferred annuity. In case you are unaware of this miracle of marketing and tax loathing, a variable annuity is basically a mutual fund wrapped in an insurance contract. You get tax deferred growth of your investment, the insurance company gets to collect fees for death benefits and management fees.

The market for this product is so vibrant that there are now some 355 variable annuity policies with 5,761 mutual fund sub-accounts. While there can be a lot of discussion about exactly how much variable annuities cost and how they compare to mutual funds, the average VA now has a total cost of 2.08 percent a year, comprised of 1.26 percent insurance costs and 0.82 percent fund costs.

One problem with variable annuities: they dont work very well for fixed income products. It doesnt make sense to put a money market fund yielding 5 percent inside an insurance wrapper that costs 1.25 percent because youve just added a 25 percent cost (1.25 percent/ 5.00 percent) to merely defer the inevitable tax bill.

While money market funds are an extreme example, the same argument applies to bond funds— the expense burden can reduce or eliminate the benefit of tax deferral. Basically, the cost burden forces you to be a long term investor in higher risk, higher return assets— equity funds.

To put VAs to a test, I did a replay of an earlier exercise. Using Morningstar Principia Pro software, I invested $10,000 in the Vanguard Index 500 fund on January 1, 1984 and paid taxes along the way. Taxes on dividends were calculated at 31 percent, taxes on capital gains at 28 percent.

At the end of 1998, it had been necessary to pay $5,590 in income taxes. In spite of that, the original investment had grown to $92,483 and included $66,144 in unrealized capital gains. The calculated return was 15.99 percent. If the entire investment was liquidated and all taxes paid at the current 20 percent capital gains rate, there would still be $79,254 left.

Not bad. Not bad at all.

Query: How does this taxable investment compare to its variable annuity competitors?

Answer: Very, very well.

The Morningstar database showed 122 variable annuity sub-accounts with a history of at least 15 years. Of that number, 61 were fixed income fund sub-accounts, 13 were domestic hybrid (or balanced) accounts, and 48 were equity funds. As you might expect, equity sub-accounts were at the top of the list, money market funds at the bottom.

Ranked simply by how much money had been accumulated at the end of the period, the simple, cheap, and taxable Vanguard Index 500 fund placed 8th. It was, in other words, in the top 17 percent of the 48 equity fund sub-accounts then available. It was also 8th on the entire list of 122 sub-accounts with 15 year records. It ranked this high in spite of paying taxes every year for 15 years.

( The table below shows the results.)

Couch Potato Equities vs. The Top 10 Variable Annuity Equity Funds

Holding Final Value Cumulative TR % Annlzd TR % Liquidation Value Taxes* After Tax Value
NE Zenith Accum Cap Growth







Guardian VG 2/Guard Stock







Hartford DCPlus-Q 20th Cent Ultra














Hancock Accom U Growth & Income







Hancock Accom U-SP Growth & Inc







Prudential VCA-2 Account (Q)







Vanguard Index 500







Equit Equi-Vst-S100-200 Common







Hartford DCPlus-Q Stock







MassMutual Panor-Q Growth







Source: Morningstar Principia Pro, December 31, 1998 data

On this basis alone, prudent investors should favor a low cost, tax efficient fund over the expenses, penalties, and high terminal tax rates of variable annuity products.

But the comparison doesnt end there. If you liquidate the index fund, youll only pay taxes at capital gains rates— 20 percent. This will net you $79,254. If you liquidate your variable annuity holding, youll pay taxes at ordinary income tax rates, 31 percent in this example. As a result, Vanguard Index 500 fund moves up to second place.

Liquidation, of course, is an extreme move that few financial planners would recommend. If you go through the same exercise making a more realistic assumption that you will withdraw 10 percent a year, the Vanguard Index 500 fund still comes in second, beating all but one fund by a wide margin.

Why? Because variable annuity withdrawals are all taxable income first, taxed at ordinary income rates. When you liquidate 10 percent of the taxable equity fund shares, however, some of it is regarded at non-taxable original investment. Then the remainder is taxed at the 20 percent capital gains rate.

Bottom line: Variable annuities are a "cant get there from here" product. If you have the time necessary to avoid early withdrawal penalties youll probably do better in an inexpensive, tax-efficient index fund or tax-managed equity fund.

Of course, youll have to buy it on your own.

Want to read more? Visit Variable Annuity Watch, a reader on variable annuities including earlier versions of the same research.