The Tragedy of Variable Annuities

Variable annuities can be great tax-advantaged investment tools for the right people. But the boom in Variable Annuity sales hasn’t benefited many people. A large percentage of variable annuities are bought by people who won’t benefit from them and might even be taking a step backward. But there is good news on the variable annuity front if you analyze your options carefully and determine the right move for you.

The tragedy of variable annuities is that many of the wrong people own variable annuities. A high percentage of variable annuities are purchased through IRAs. An IRA already is a tax-deferred investment vehicle. There is no point in stuffing another tax-deferred vehicle inside it by purchasing a variable annuity through your IRA. Simply purchase the mutual funds you want through your IRA and save the annuity expenses.

Another tragedy of variable annuities is that many buyers are too old to benefit from them. A variable annuity allows you to invest in a group of mutual funds. To get the tax deferral of an annuity, you have to pay mortality and administrative expenses in addition to the regular mutual fund management expenses. There also might be additional sales expenses. The result is that the average variable annuity has expenses of 2.15%, while the average stock mutual fund has expenses around 1.5%. Those additional expenses are the price you pay for the tax deferral.

I’ve run the numbers many times. It always turns out that to make up for the extra expenses, you have to let income and gains compound in the variable annuity for about 15 years. The compounding period needs to be longer if you want to do more than break even.

You can reduce the break-even point by using a low-cost variable annuity. And the break-even point also is below 15 years if you would do a lot of trading in a taxable account and incur ordinary income taxes on your gains and income. But for most people the break-even point is around 15 years. But there is good news for investors who can benefit from variable annuities by investing for the long-term.

Vanguard, the low-cost variable annuity leader, recently reduced its mortality and expense ratio for the third time in three years. That brings the annual expenses down to 0.57% to 0.85%, depending on which funds you invest in. Vanguard also has increased the number of funds available to its annuity investors to 13. Now among the choices is one of my recent favorite asset classes, real estate investment trusts. The Vanguard Variable Annuity now lets you build a complete diversified portfolio.

Another good sign for investors is the entry of investment giant TIAA-CREF. The firm traditionally offered its services primarily to teachers and university employees but recently began offering products to the general public. Its new annuity, Personal Annuity Select, will have the lowest expense ratio in the industry – 0.37% total expenses. That should put the pressure on other annuity providers to lower their costs.

The downside of the TIAA-CREF annuity is that there are only two investment offerings, a fixed annuity and a Russell 3000 stock index fund. The annuity is approved for sale in New York, Iowa, South Dakota, Arkansas, Ohio, Indiana, Alabama, and the District of Columbia. Approvals are being sought in all states.

Low-cost annuities also are available from T. Rowe Price, Scudder, and Fidelity.

How can you tell if a variable annuity is for you?

Exhaust all other tax deferral options such as IRAs (or tax-free Roth IRAs), 401(k) plans, and company pension plans. Then be sure any money you might put into a variable annuity won’t be buy-and-hold investments that you don’t sell for a long time and that don’t generate a lot of taxable annual distributions. These buy-and-hold investments end up generating tax-advantaged long-term capital gains, while annuity withdrawals are taxed as ordinary income.
Still not sure? T. Rowe Price has the best materials for analyzing the options and making a decision. You can order their Variable Annuity Analyzer software or use it for free on their web site.