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Variable Annuity Watch, 2012
March 08, 2013

Variable Annuity Watch, 2012

Written By: Scott Burns

The big claim for variable annuities has always been that they allow investors to invest and watch their money grow, tax deferred, until they need it. The basic idea is that you can avoid paying at a high tax rate now and pay at a lower tax rate later, probably when you are retired.

Sounds good, right?

Unfortunately, what seems to be a good idea doesn’t work in practice, largely due to fees. Nothing shows this more clearly than results over the last decade. In a sense, investors got hit with a double whammy: low returns and high fees.

How could low returns matter, you might ask? After all, low returns were universal. Whether you chose mutual funds, exchange traded funds, or variable annuities, if you invested in domestic common stocks you got low returns by historical standards.

The problem is that the fees work like the tax you’re trying to defer. According to the Morningstar variable annuity database, a typical VA contract carries insurance costs of 1.00 to 1.25 percent. So in a period when domestic stocks provide a historically normal return of 10 to 11 percent a year, the cost of the insurance “wrapper” that provides tax-deferral would take about 10 percent of the return. Have a really good period— such as the 1990s— and the insurance cost burden is less.

But the fee burden becomes punitive in low-return period. Over the last 5 years, for instance, the return of the Vanguard Total Market Index (a proxy for all U.S. stocks) was 2.18 percent a year. So if you were investing via a variable annuity with an insurance expense of 1.1 percent a year, the cost of the insurance wrapper was a whopping 50 percent of your return. That’s higher than the highest of our new tax rates.

So you’ve paid 50 percent of your return just to get tax deferral on what’s left. And it would have been a bit worse if you had invested in the Vanguard 500 Index (a proxy for domestic large cap stocks) because it returned less. Over the last 5 years its return was 1.57 percent, indicating that a 1.00 percent insurance wrapper cost would have taken 64 percent of the return.

To make matters worse, the return of the average domestic stock fund or the average balanced fund was lower than any of the index returns over the last one, three, five and ten year periods.

Low-Cost Index Investing Beats High-Cost Variable Annuity Investing, Yet Again

This table compares the annualized returns of two major categories of investment funds over four different time periods ranging from the last year to the last 10 years. In all periods, a simple, low-cost index fund provided a higher return than its higher cost variable annuity competition.

  1 year 3 years 5 years 10 years
Domestic Equities
Vanguard Total Market 16.25 11.18 2.18 7.83
Vanguard 500 Index 15.83 10.72 1.57 6.99
Avg. Large Blend VA 13.98   7.98 (0.21) 5.86
Balanced Funds
Vanguard Balanced Index 11.33 9.46 4.14 7.07
Avg. Mod. Allocation VA 11.02 6.77 1.45 5.50

At this point the “yes, but” sales crew would like to object. “Yes, but— you’re talking about an index versus the merely average VA domestic stock fund. You could have done a lot better with an above-average managed fund.”

Yes, you could have— but the odds are greatly against it. Over all four time periods, the worst performance by either the S&P 500 fund or the Total Market fund was when the Vanguard 500 Index ranked 606th against 3,051 variable annuity funds over the last year. In other words, the worst either index fund did was to beat 80 percent of its variable annuity competition.

Much the same happens when you examine the performance of variable annuity balanced funds against the Vanguard Balanced Index fund, a proxy for traditional 60/40 balanced portfolios. The index fund beat 90 percent of its VA competition over the last 3, 5, and 10 year periods. In 2012, it was disappointing. It beat only 50 percent of its variable annuity competition.

As a practical matter, while these figures are yet another example of why variable annuities are a product sold by the commission motivated, they actually understate the superiority of avoiding fees and gimmicks through index investing.

What could make these performance figures worse? Taxes.

The return from a variable annuity is taxed, upon withdrawal, at ordinary income rates. Those were just increased. Much of the return from a broad index fund, however, will be taxed at the capital gains rate. That’s now 20 percent, up from 15 percent last year. So index funds beat the tax deferred variable annuity funds before taxes… and may beat them by still more after taxes.

Is there a silver lining in this dark cloud of variable annuity failure?

Yes, but only if you have a dark sense of humor.

If President Obama continues to succeed with raising the tax rate on capital gains so that it approaches the tax rate on ordinary income, tax deferral could become something to value.

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This article contains the opinions of the author but not necessarily the opinions of AssetBuilder Inc. The opinion of the author is subject to change without notice. All materials presented are compiled from sources believed to be reliable and current, but accuracy cannot be guaranteed. This article is distributed for educational purposes, and it is not to be construed as an offer, solicitation, recommendation, or endorsement of any particular security, product, or service.

Performance data shown represents past performance. Past performance is no guarantee of future results and current performance may be higher or lower than the performance shown.

AssetBuilder Inc. is an investment advisor registered with the Securities and Exchange Commission. Consider the investment objectives, risks, and expenses carefully before investing.