Variable Annuity Watch, Continued

Variable Annuities, the insurance based product that has no reason to live, continue to march on, building assets for the insurance industry. As a by-product they build tax liabilities for investors while lowering their returns with high expenses.

If you have developed the impression that I don’t like this product, you are correct. The reason is simple: the numbers don’t work. They didn’t work when tax rates were higher. They certainly don’t work when dividends and capital gains are taxed at only 15 percent.

The best circumstance for variable annuities is when you invest shortly before a major market decline and then die. This will leave your heirs the value of your original investment because of the death benefit provision built into the contract. If you had had the foresight to invest in the most speculative funds at the market top and had the good sense to die at the market bottom, you could have made a real killing— your heirs would have broken even.

You would, of course, have to deal with the substantial inconvenience of death.

More than two years have passed since I did my last Variable Annuity Watch exercise. The equity market has recovered nicely and a good number of funds have done better than the Vanguard 500 Index. Even so, the long-term results still favor investing directly and paying taxes as you go. Two years ago I found, and showed, that the Vanguard 500 Index fund provided better performance than all but a handful of large established variable annuity sub-accounts.

Fast-forward two years: Today, the results are similar. All rates of return are lower, reflecting the 2000-2002 bear market.  But direct investing is still the best choice.

Here’s how I came to that conclusion. Using the Morningstar Principia database— one of the nice tools Morningstar provides for financial planners— I screened for domestic equity funds that have a track record of at least 15 years and current assets of at least $500 million. The result is a list that has some survivor bias.

The 24 funds on this list have an average performance that beats the averages of the 307 domestic equity funds with 15-year histories but fewer assets. At ten years, for instance, the average annualized return of the 24 large funds is 8.27 percent. That’s well ahead of the 7.35 percent average annualized return of the 307-fund universe of surviving sub-accounts with a 15-year history.

So this deck, if it is loaded in any way, is loaded to favor the variable annuities.

Over the last 15 years the best of the sub-accounts, Hartford The Director Capital Appreciation Fund, has clocked in with a pre-tax return of 12.63 percent. That’s well ahead of the 8.55 percent average for the 24 funds and nicely ahead of the 10.21 percent pre-tax return of the Vanguard 500 Index fund. Pre-tax, the taxable index fund would have ranked fourth.

If you assumed both dividends and capital gains were taxed at 28 percent during the entire 15-year period, the index fund annualized return falls to 9.40 percent. (Those were the rates through 1996 but capital gains taxes were lowered to 20 percent in 1997 and 15 percent in 2003 so, again, we’re putting our thumb on the scale to favor the annuities. They haven’t paid out any money to cover tax liabilities yet.) This would drop the index fund to 7^th place. In the entire universe of 307 it would rank 39^th— in the top 13 percent.

The variable annuities have 15 years of accumulated tax liabilities, all taxable at ordinary income rates. In the index fund we have a higher cost basis due to reinvestment. We also have unrealized capital gains taxable at 15 percent. Adjust for the tax liabilities and the index fund after-tax return drops to 8.79 percent. That’s only 30 basis points behind the top performing variable annuity fund.

So it takes second place. On the same basis it would have placed 4^th among all 307 sub-accounts with at least 15 years of operation.

Not bad for being a passive twit who pays taxes.

On the web:

Past Variable Annuity Watch Columns:

http://www.dallasnews.com/s/dws/bus/scottburns/variableannuitywatch/

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, 2004