Alternatives To High Expense Variable Annuities

Some products are bought. ( Ice cream cones and fast cars are in this category.)

And some products are sold. (Encyclopedias and variable annuities are in this category.)

You and I are left to ponder why.

A recent Wall Street Journal article notes that less than 6 percent of the $73.8 billion in variable annuity products sold in 1996 were no load products. This is a tiny percentage compared to regular mutual fund sales. Straight no-load fund sales accounted for 36 percent of all sales in 1996 according to the Investment Company Institute. That’s six times as much.

The article goes on to speculate that the complexities of variable annuity products discourage people. It takes a trained financial expert to convey the wonders of tax deferred investing to people such as you and me, otherwise known as the benighted, dimwitted public. Then, when the saintly, patient financial planner finally succeeds in producing a dim light in our dull brains, we rush invest our money.

I beg to differ.

Enlightenment and understanding has nothing to do with it. Forceful selling does.

So here’s a map. If you have been approached to invest in a variable annuity, this is what you need to know about the product being sold and its many alternatives.

First, in case you don’t know what a variable annuity is, it is an insurance based product that takes a variety of mutual funds and wraps them in an annuity contract. The immediate result is that you can invest an unlimited amount of money in any combination of those funds, move from one fund to another, and have all your investment income tax deferred. There will be no taxes until you start taking money out of the contract.

Sounds pretty neat, doesn’t it? Build your assets and starve the tax collector— clearly an idea with virtue.

The problem is that you don’t get tax deferral for free. You have to pay mortality and other expenses to the insurance company that provides the wrapper. These expenses can absorb a good deal of your investment return.

This is not hyperbole. In a recent examination of the Morningstar database for variable annuities, I found that insurance expenses averaged 1.27 percent a year but ranged from a low of 0.15 percent ( TIA-CREF) to a high of 1.77 percent ( Paine Webber Milestones).

The product that is SOLD is the stuff with the high expenses.

You can make a dramatic difference in your results by shopping for a variable annuity product with low expenses instead of high expenses. Suppose, for instance, you have a choice between buying a fund with wrapper costs that range from the top to the bottom? All other things being equal, if the fund has a return of 10 percent and you hold the investment for 20 years, $10,000 will grow to $65,464 under the 0.15 percent wrapper and $48,635 under the 1.77 percent wrapper. Quite a difference.

If the salesman says, “Oh, but we have the best funds.”, don’t believe him. The fact is that many funds are sold under a multitude of insurance wrappers. You can buy Fidelity Equity-Income fund under a whopping 57 wrappers that range in cost from 1.65 percent to 0.80 percent. You can buy the T. Rowe Price Equity Income fund under six wrappers that range from 1.40 percent to 0.55 percent. Both are excellent funds. It’s the wrappers that differ.

Here are the names, phone numbers, and insurance wrapper costs for five no-load, low cost providers:

Five No Load, Low Cost Providers of Variable Annuities

* Note: this product is available to groups, not retail

Source: Morningstar/ Principia

As I pointed out in a recent column ( 4/10/97), in a test of one tax efficient equity index fund, the benefit of tax deferral was 1.8 to 1.25 percent, depending on how you calculated. If you pay that much in insurance fees there will be no benefit, just extra expense.

After eliminating the high expense variable annuities, the low expense variable annuities must still be measured against:

• investment in a tax managed fund ( there are now 17, 12 with no front end load);
• investing in a tax efficient index fund (there are now 127 index funds);
• investing in a non deductible IRA;
• or investing in individual stocks for capital gains.

Each can provide close competition. The odds, on the other hand, are stacked against the sold products where the expenses consume the benefits.

This information is distributed for education purposes, and it is not to be construed as an offer, solicitation, recommendation, or endorsement of any particular security, product, or service.

Photo by Jean Balzan

A.M. Universal, 1997