What’s Left For Variable Annuities?

Some of the strongest opponents of the 2003 tax cuts were insurance companies. It’s no wonder. The new law significantly tarnishes the appeal of variable annuities and cash value life insurance. Market forces, meanwhile, are making fixed annuities less appealing to some investors.

A Variable Annuity allows the owner to select how the account is invested among mutual fund choices offered by the insurer. All income and gains compound tax-deferred within the annuity. When income and gains are distributed, they are taxed as ordinary income. One can view a variable annuity as an IRA with no contribution limit and no deductions for contributions.

The tax deferral of variable annuities is attractive, but you pay two steep costs to get that advantage.

One cost is that long-term capital gains are converted into ordinary income. Gains from mutual funds that are held for more than one year in a taxable account face a maximum tax rate of 15%. Any gains distributed from a variable annuity are taxed as ordinary income.

The 2003 tax law increased this cost by reducing the top rate on long-term capital gains by more than the tax rates on ordinary income are reduced. A taxpayer in the top bracket now will pay a 35% rate on ordinary income but only 15% on long-term capital gains. In addition, any dividends that would be taxed at the ordinary income rate when distributed from the annuity would be taxed at 15% now if earned in a taxable account.

The other cost is the additional expenses imposed by the annuity. In addition to normal mutual fund management and trading expenses, the annuity imposes a mortality or insurance charge plus its own administrative expenses. These additional expenses range from less than 1% of the account on the few low-cost annuities available to over 2% on high-cost annuities.  The average additional cost among variable annuities is about 1.4%. A variable annuity also might impose a front-end load or commission or a surrender fee or both.

Under the old tax law, I found that it took about 10 years for a low-cost variable annuity’s benefits to overcome the disadvantages. A high-cost annuity took at least 15 years to overcome the disadvantages. I plugged the new numbers into my variable annuity analyzer program to see how the new rules affect the appeal of variable annuities. Here is what I found:

Under the new law, a tax-wise investor in the top tax bracket never would benefit from investing through a variable annuity. The tax-wise investor earns only long-term capital gains in the portfolio, paying the 15% tax rate on accumulated gains. The after-tax value of such a portfolio in a taxable account always would exceed the after-tax value of a variable annuity if the two achieved the same investment returns before expenses and taxes. This conclusion holds true whether the annuity is high cost, average cost, or low cost.

Even a low-cost annuity with annual expenses of only 0.7% does not make sense for the tax-wise investor. The higher taxes on distributions and higher expenses are too big a burden for the tax deferral to overcome.

I tried scenarios for less tax-wise investors. Even when 50% of the annual returns in a taxable account were taxed at a combination of long-term capital gains and ordinary income tax rates, the taxable account still is a better deal for the top tax bracket investor.

Suppose an investor has 75% of the annual returns from a taxable account taxed at the 35% rate. Even then, according to my program, it takes 22 years for the tax deferred compounding of the variable annuity to overcome its higher expenses and having the ordinary tax rate imposed on all its distributions. Remember, this result is for a low-cost annuity with 0.70% annual expenses.

Suppose the investor is in the 28% tax rate, so there is a smaller gap between the long-term capital gains rate and ordinary income rate. Suppose also that this is not a tax-wise investor, so 75% of annual returns in the taxable account are taxed at the 28% rate. Even then, it takes 24 years for the variable annuity to have a higher after-tax value than the taxable account.

The break-even point is much shorter for an ultra-low cost annuity with annual expenses of only 0.20%. Then, the annuity comes out ahead after only 13 years of compounding if the investor is not tax wise and has 75% of annual returns taxed at the 28% rate. But if the investor is moderately tax-wise and only 35% of annual returns are taxed at the 28% rate, it takes the ultra-low-cost variable annuity 34 years to have a higher after-tax value than the taxable account.

The above conclusions were reached assuming that each portfolio was fully invested in stocks and that the stocks returned 9% annually. Are the results different if the variable annuity is in high-yielding investments that would be fully taxable outside the annuity, such as high yield bonds?

I assumed an investor in the 28% bracket earned 7% annually in ordinary income. This return is available from high yield bonds, preferred stock, corporate bonds, real estate investment trusts, and a few other investments. The after-tax income in the taxable account is reinvested and compounded each year.

Here, the variable annuity makes some sense. The ultra-low-cost variable annuity with 0.20% annual expenses has a higher after-tax value than the taxable account after only four years. With a $100,000 investment, after 10 years the variable annuity’s increased after-tax value is about $5,000, after 15 years the advantage is $15,000, and after 20 years the variable annuity is about $34,000 more valuable than the taxable accounts.

When the annuity’s expenses are raised to 1% annually, the variable annuity’s advantage disappears. In that case, it takes the variable annuity 27 years to have a higher after-tax value than the taxable account.

If the investor is in the top 35% bracket, the 1% expense annuity has a faster pay off – only 22 years.

Keep in mind that even under the old law, a variable annuity needed to own investments with a high return to overcome its additional expenses. A low to moderate return investment, such as a general bond fund, is not a good investment for a variable annuity.

While variable annuities were advantageous only to select investors in the past, they make sense for even fewer investors today.

Before considering a variable annuity, be sure you have taken full advantage of other tax-deferred accounts that have lower costs, such as IRAs and 401(k)s. Even nondeductible IRAs should be maximized before considering an annuity. Also, put the maximum amount in a Roth IRA if you are eligible.

Before taking the plunge with a variable annuity, consider investing in a tax-wise way through a taxable account. Hold investments for the long-term so you incur only long-term capital gains taxes. Invest in individual stocks or fund you will own for longer than one year. Select mutual funds that make few annual distributions.

If you buy a variable annuity, be sure it is one with no load and rock bottom expenses, such as those offered by Vanguard and TIAA-CREF. Other mutual fund firms and brokers such as Charles Schwab & Co. also offer variable annuities with low, but not rock bottom, costs.

In addition, try to use the variable annuity for investments that are not tax-advantaged on their own and that have relatively high returns. Plain vanilla bonds don’t belong in a variable annuity.

Fixed annuities also have taken their lumps recently because of market conditions.

Interest rates in the markets are dropping, so yields on fixed-rate deferred annuities also are falling. The minimum guaranteed rate on most annuities used to be 3%. In recent months, most insurers began dropping the rate to 1.5% or less. In 31 states, the guaranteed rate now is 1.5%. In 11 states, the rate is the five-year treasury rate minus 1.25%, but no lower than 1%.

Many insurers no longer are offering short-term fixed deferred annuities. You’ll need to sign up for at least five years to buy a new deferred annuity. Jackson National, a major annuity seller, is paying 2.7% the first year on a six-year annuity with a 1.5% guarantee. Investors who convert a deferred annuity into an immediate annuity now will get payments based on a very low interest rate.

The low yields do not necessarily mean an investor should avoid deferred or immediate fixed annuities. Annuity yields still have the same relationship to market interest rates that they had in the past. With market yields at such low levels, annuities also will pay low yields. Annuities still have their advantages of tax-deferral and the insurer’s guarantee.

The big disadvantage of an annuity now is that if interest rates rise, there usually is a lag before the rate credited on deferred annuities rises to meet the new market rates. In addition, someone who buys an immediate annuity will be locking in today’s low rates for the duration of the annuity. That investor might want to wait or look for alternatives to annuities.