Who gets what?
That’s the key question in any investment transaction.
So let’s examine the most common investment offers in those terms, having put them in black boxes labeled “A”, “B”, and “C.”
Black Box A. The offer from box A is that you will put up 100 percent of the money and take 100 percent of the risk. The box providers will take 0 percent of the risk and put up 0 percent of the money. But they will take about 19 percent of the return. Your tax bill on this transaction will take about 25 percent of your return after their expenses if you are in the 25 percent tax bracket. More if you are in a higher tax bracket. At best, you’ll get 56 percent of the return on your money.
Black Box B. The offer from this black box is slightly better. You’ll still put up 100 percent of the money and take 100 percent of the risk. But the providers will only take about 13 percent of the return. Your tax bill could take as much as 25 percent of the remainder but will probably take somewhat less. You’ll get to keep at least 62 percent of the return on your money. In rare instances, you could keep 72 percent of the return.
Black Box C. The offer from this black box is a good deal better. As usual, you’ll put up 100 percent of the money and take 100 percent of the risk, but the providers will take less than 2 percent of the return. Your tax bill will be about 15 percent of your return. Here, you’ll get to keep 83 percent of the return on your money.
I have a lot of trouble thinking that the offer from Black Box A is a good deal.
Black Box A is the average variable annuity, invested in large-blend domestic stocks. There are 1,017 sub-accounts that invest this way and that have 10 year track records. On average, they have total annual expenses of 1.90 percent and they provided a pre-tax return of 8.07 percent annualized over the 10 years ending August 31. Since the entire accumulation had the blessing of tax deferral, anyone in the 25 percent tax bracket can expect to see a still lower net return. Your after-expense and taxes return would be 6.05 percent.
Black Box B is the average taxable domestic equity mutual fund that invests in large-blend stocks. There are 370 such funds with 10-year track records, with an average annual expense ratio of 1.20 percent. They did a bit better, returning a pre-tax 8.37 percent annualized over the period. Most of the funds, however, would have given up their advantage by having to make tax payments over the 10-year period.
Black Box C is the Vanguard 500 Index fund, the oldest and least expensive of the major index funds. Today, there are a number of comparable expense funds and lower cost exchange traded funds (ETFs). With an annual expense ratio of only 0.18 percent, it provided a 10 year annualized return of 10.01 percent, before taxes. According to Morningstar, its return after sale and payment of all taxes— at pre-2003 tax cut rates— was an annualized 8.08 percent.
Its after-tax return, in other words, was the same as the 8.07 percent pre-tax return of the average variable annuity sub-account that invested in the same area.
Now let’s ask another question.
Of the 1,017 variable annuity sub-accounts that invested in a comparable large capitalization stock area, how many earned 10.01 percent before taxes? Answer: 122. So only one in eight of the comparable variable annuity sub-accounts did better than the index over the last decade. Only 54 of the 1,017 variable annuity sub-accounts did better than the 10.76 percent annualized return it would take to overcome the disadvantage of the 25 percent tax bracket[i] and only 17 sub accounts provided the 11.53 percent annualized pre-tax return required to overcome the liability of the 30 percent tax rate.[ii]
However you measure, Black Box A wasn’t a very good deal for the investor.
In the next 10 years the comparison will be worse.
Why? Tax rates on capital gains and dividends have been cut to 15 percent. Anyone in the 25 percent tax bracket— or higher— will get a better deal by paying lower taxes now rather than using deferral to pay higher rates later.
Why am I writing about this?
Simple. According to the National Association for Variable Annuities, new sales of variable annuities continue to run at a $120 billion annual rate.
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: Photo by Burak Kebapci on pexels.com
(c) Scott Burns, 2022