Friday, April 4, 1997
Variable Annuities: A Way to Plan
for the Future, or a Tax-Deferred Bad Investment?
by
GWRunkle
Some time ago, I promised a reader that I would write an article on variable annuities. I hate to admit it, but I wasn't looking forward to it. I knew I'd have to descend into spreadsheet hell to make my point, so I kind of delayed it. Then, stupid me, I write a Fribble about how I couldn't think of anything to write. Norma then reminded me of my promise.
What is an annuity? There are two different types, variable and fixed. With a fixed annuity, you invest a certain amount of money, and the investment company promises to pay you a fixed payment starting at a certain time, and ending at a certain time (which might be the end of your life). A variable annuity is like a mutual fund, you invest how you like, and the amount you get at the end of the period is solely dependent on how well your investments perform.
A variable annuity, unlike a mutual fund, also includes an insurance component. If you die before you can collect on that annuity, whoever your beneficiary is collects as a minimum the principal you invested. Because of this, the fees are higher to maintain an annuity than your usual mutual fund. Additionally, a lot of annuities charge for pulling out your money before a certain number of years. You also pay a 10% tax penalty if you pull out the money before age 59 1/2.
You do have the benefit of tax-deferral. The gains on your annuity aren't taxable until you take the money out, which is likely to be after you retire and have a lower income. That is the way a lot of insurance companies peddle these high-cost mutual funds. The agent will show you tables showing the "advantages of tax-deferred investing." The one I got years ago showed how such-and-such percent return tax-deferred was the same as so-much-more not tax deferred. It seems like a non-deductible IRA with no upper limit, just higher fees, lower returns, and surrender charges. Oh yeah, tax penalty too if I needed the money. How could I resist? I still have that annuity, although I don't put any money in it any more.
Isn't the tax deferral a good thing? Does it compensate for the traditional market under-performance of mutual funds coupled with higher fees? No. First off, there is an index variable annuity from Vanguard, where you at least do almost as well as the market. I'm not in it, because I have a surrender charge to pay on the annuity I'm stuck in if I pull out before five years. Worse yet, Vanguard has very low fees and charges no surrender charges. Did you hear me scream when I discovered I could have moved that annuity into in an index fund? I just moved that money from the original fixed income investment last year, now I'm stuck another five in the present mutual fund. Let me bang my head against the wall a few times, and I'll continue...
There, that feels much better. I came up with a theory. Why do you need "tax-deferred" investing if you don't sell your investments until you retire? You don't pay capital gains tax until you sell anyway. Suppose you feel that holding an individual stock for 20 years is too risky. Heck, the world might finally get tired of Coca Cola after 120 years or so. How bad a tax bite do you pay on an index fund where the turnover of stock is very low? As an experiment, I made up a spreadsheet for Vanguard's Index 500 fund, to see how bad your tax hit would be. How did it come out?
Let's say you invested $10,000 on January 1, 1996. At the end of the year, you would have had to declare a whopping $1.72 in short-term capital gains. Long-term gains would be a little worse, at $41.75. Dividend income would be the highest at $222.15. If you were paying taxes at the top rate (39.6%), your total tax bite would be about $100 for that mutual fund at the end of the year. As a percentage of its value at the end, I figured 0.82%. Coincidentally, that is the expense ratio that Vanguard quotes for its expense ratio for variable annuities. If you have a taxable income of less than $96,900 a year, you are paying a 28% tax rate, and your taxes are going to be about $75, or 0.61%. Vanguard said in its web site that if you are in the 28% tax bracket or lower, annuities are probably not a good investment. I'll go along with that. If you make more than $96,900 a year in taxable income, I hope you are doing more than reading this Fribble to plan your taxes.
Now, of course the turnover in Vanguard's Index 500 portfolio varies year to year, so the capital gains will go up and down. Also, the dividend rate tends to change, too. Even considering all that, it is hard to see how a variable annuity would be of much benefit to most of us. Ok Norma, have I answered your question sufficiently on annuities?
For those of you seeking more information on annuities and index funds, check out the The Vanguard Group Homepage.
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