Variable Annuities That Beat Taxable Funds

“Are Variable Annuities Right For Your Clients?”

That’s the title of an interesting article in the January Journal of Financial Planning. James D. Peterson and Yongling Ding, both researchers at the Schwab Center for Investment Research in San Francisco, wrote it.

“We felt, looking at the literature, that there were two extremes on the subject. Some people loved them. Some hated them. Some loved them for their tax deferral. Some hated them for their costs,” Dr. Peterson explained in a recent telephone interview. “We thought it was something worth examining objectively.”

To do that, the two researchers employed a unique and arduous method. They ran 10,000 computer simulations and compared the long-term accumulations of the same portfolio— the S&P 500— as a taxable managed fund and as a tax deferred managed fund. Their simulations even took into account the percentage of clients who would die during the investment period and the ramifications of reinvesting for the beneficiary. This has the effect of incorporating the value of the death benefit in variable annuity contracts, a factor frequently applauded by variable annuity enthusiasts and disdained by their critics.

“It isn’t so much the higher cost of variable annuities, it’s the spread.” Dr. Peterson said. While variable annuities had a higher cost burden than taxable managed funds, it was possible tax deferred compounding would allow the variable annuity investment to exceed what lower cost but taxable accounts could accumulate. Basically, it was a question of “the spread,” as he called it.

What did the two researchers find?

If you assume the investor is in the same tax bracket at all times, the taxable managed fund has a slight advantage for the first 15 years of accumulation.

At the fifteenth year it’s a dead heat. The net, after-tax accumulation in both vehicles is virtually equal— a $40,000 investment grew to about $137,000, plus or minus $1,000. The difference in net annualized returns was never more than 6 basis points— .06 percent a year.

After the 15^th year, the variable annuity starts to pull ahead. By the twentieth year the difference in net returns— the spread— is as much as 39 basis points per year. By the twenty-fifth year the net return spread is as 69 basis points.

These are not trivial differences. A 40 year old who invested $40,000, for instance, would accumulate an after-tax value of $314,194, a return of 8.59 percent annually. Invested in the researchers’ model variable annuity, the same investment would grow at 9.28 percent to $367,718. That’s a difference of $53,524.

The researchers conclude some people are good candidates for their model variable annuity— very long-term investors who aren’t likely to make changes that would incur withdrawal penalties.

Rest assured, many annuity salesmen will tout this study.

Now let’s consider the fine print.

What the two researchers simulated was a low-cost variable annuity with total annual expenses of 1.43 percent a year, .70 percent for the insurance expenses, .73 percent for the portfolio expenses. The competing taxable fund was assumed to have annual expenses of 0.86 percent and annual taxable distributions typical of managed equity funds.

These distinctions are important. According to the Morningstar database, the variable annuity universe offers 12,218 domestic equity fund choices. They have an average total cost of 2.23 percent a year. That’s 80 basis points greater than the expenses of their model variable annuity. So the average offering costs more (80 basis points) than the maximum benefit (69 basis points) offered by their model annuity if you invest for 25 years.

If you look closer, 11,229 of the 12,218 domestic equity choices have costs that are at least 69 basis points greater than the 1.43 percent figure used in the Journal of Financial Planning study. This means 92 percent of what the industry offers the public has costs that fully absorb the maximum return advantage found in the study. Another 554 offerings, with expenses between 1.43 and 2.12 percent absorb some portion of the long-term advantage in higher costs.

Only 435 offerings qualify as true competitors having annual expenses of 1.43 percent or less.

Now let’s go a step further. Let’s check the same 69 basis point spread against index investing. To beat a low cost market index fund total annual costs for the variable annuity can be no higher than 89 basis points— 20 basis points for the fund plus the 69 basis points maximum advantage the researchers calculated.

How many of the 12,218 offerings qualify? Fifty-seven.

Yes, you read that number right. 57. Of those, only 22 have at least $50 million in assets.

Readers interested in the original article can read it on the web at:

http://www.fpanet.org/journal/articles/2003_Issues/jfp0103-art9.cfm

Earlier Scott Burns columns on variable annuities:

http://www.dallasnews.com/business/scottburns/alsoonline/variableannuitywatch.html

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.

(c) A. M. Universal, 2003