If the federal income tax did not exist, the insurance industry would beg to bring it back.
I’m not kidding. Nothing sells financial products better than avoiding or deferring taxes. And it happens that the insurance industry has a lock on tax deferral through annuity contracts.
Yes, it’s time for my annual Variable Annuity Watch column. Let’s see if this oversold product has done any better this year against a simple, cheap index fund investment. So far, the product is batting zero.
Before we look at the broad figures, let’s ask a rude question. If the cost of investing in a variable annuity exceeds your expected tax rate, should you bother?
Here’s the math. The Morningstar Principia database tells us that the average total expense for a large-blend annuity sub-account, usually a mutual fund, is 1.86 percent a year. It costs this much in a time when many observers are expecting stocks to provide a lower total return than in the past.
This expectation came from simple arithmetic. It didn’t come from an oracle. The dividend yield on stocks is low. Only 1.8 percent on the S&P 500. That low yield, alone, may knock about 2 percent a year off long-term returns. Higher than average price earnings multiples may do some damage, too.
What does a lower future return mean? Instead of the historical norm of a 10 percent annualized return, the future return may be closer to 8 percent. So, that 1.86 percent annual fee will take at least 18.6 percent of a historical return and could take as much as 23.3 percent of expected returns. Either way, that’s quite a bit to skim off the top.
Worse, tax deferral means higher taxes when you finally withdraw money from your investment. If you invest in stocks through a taxable account, the most you will pay is 15 percent on dividends or long-term capital gains. If you invest through a variable annuity, you pay taxes on your accumulated return at regular income tax rates.
Here’s a little more arithmetic. You’ve paid out at least 18.6 percent of your return in fees. Then, you may pay 25 percent, or more, in taxes rather than the 15 percent rate on dividends and capital gains when you take money from your variable annuity.
You can see the impact of fees by comparing the annualized returns of a major index fund with average variable annuity funds. I used the Vanguard 500 Index (ticker: VFINX, annual expense 0.17 percent) for this. I compared it to the average of all large blend variable annuity sub-accounts.
- In the 12 months ending July 31, the annuities averaged 14.57 percent. That’s 2.18 percent less than the 16.75 percent return of the index fund.
- In the last 3 years the annuities averaged 14.18 percent. The index clocked in 16.66 percent, 2.48 percent higher.
- Over the last 5 years, the annuities averaged 14.26 percent. The index fund returned 16.62 percent, an advantage of 2.36 percent.
- Over the last 10 years the annuities averaged 6.50 percent. The index returned 7.88 percent. That’s a lead of 1.38 percent.
Of course, you could do better than average by making a brilliant fund choice. But the odds are against doing that. How many sub-accounts beat the index fund? Over the last year, 3 years, 5 years and 10 years: 19.1 percent, 7.3 percent, 4.1 percent and 7.0 percent, respectively. The odds for selecting a winning fund aren’t good.
These figures, by the way, overstate the percentage of subaccounts that beat the index. How come?
It’s called “survivor bias”— the record only shows the survivors. It doesn’t tell us about the sub-accounts that began any period, but didn’t survive to the end.
These dismal results are not limited to large blend funds, the most popular of all fund categories. I found a similar disadvantage in moderate allocation (balanced) funds. These funds average 2.09 percent in expenses. The Vanguard Balanced Index fund costs 0.18 percent. It beat the variable annuity average in each period out to 10 years. Over the last year the annuity funds trailed by 1.37 percent. They trailed by 2.54 percent, 2.10 percent and 1.5 percent over the last 3, 5 and 10 year periods.
And how about brilliant selection? The variable annuity sub-accounts had only a 19.1 percent, 9.7 percent, 10.9 percent and 12.9 percent chance of beating the simple index fund over 1, 3, 5 and 10 years, respectively.
Needless to say, you will never see such comparative figures from your friendly salesperson/adviser.
On the web:
Scott Burns, collected Variable Annuity Watch Columns
http://assetbuilder.com/category/scott_burns/variable_annuity_watch
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, 2014